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Course code: BUSI 3001

Lecturer: Mr. Edward Bahaw

Assignment #2: Application of Capital

Asset Pricing Model (CAMP) theory to
ANSA Merchant Bank


The theoretical underpinnings of CAPM
The CAPM was built on a model portfolio developed by Harry Markowitz in 1959. In the
Markowitzs model, an investor selects a portfolio at time t-1 that produced a stochastic
return at t. The model assumes investors are risk averse and when choosing among
portfolios, they are only interested in the mean and variance of their one-period investment
return. Consequently, investors choose mean variance efficient portfolios, in the sense that
1. Minimize the variance of portfolio return, given expected return
2. Maximize expected return, given variance. Therefore, the Markowitz approach was
often called the mean variance model.
The portfolio model uses an algebraic condition on asset weights in mean-varianceefficient portfolios. The CAPM turns this algebraic statement into a prediction that can be
tested about the correlation between risk and expected return by ascertaining a portfolio
that must be efficient if asset prices are to clear the market of all assets (Fama & French,
The Logic of CAMP
Sharpe (1964) and Lintner (1965) included two key postulations to the Markowitz model
to identify a portfolio that must be mean-variance-efficient.
1. The first assumption is complete agreement: given market clearing asset prices at t1, investors agree on the joint distribution of asset returns from t -1 to t.
2. The second assumption is that there is borrowing and lending at a risk-free rate,
which is the same for all investors and does not depend on the amount borrowed or
Figure 1 below illustrates portfolio opportunities and explains the theory behind CAMP.
The horizontal axis shows portfolio risk, measured by the standard deviation of portfolio
return; the vertical axis shows expected return. The curve abc, which is called the
minimum variance frontier, traces combinations of expected return and risk for portfolios
of risk assets that minimize return variance at different levels of expected return. (These

portfolios do not include risk-free borrowing and lending.) The trade-off between risk and
expected return for minimum variance portfolios is apparent. For example, an investor
who wants a high expected return, perhaps at point a, must accept high volatility. At point
T, the investor can an intermediate expected return with lower volatility. If there is no riskfree borrowing or lending, only portfolios above b along abc are mean-variance
efficient, since these portfolios also maximize expected return, given their return
Adding risk-free borrowing and lending turns the efficient set into a straight line. Consider
a portfolio that invests the proportion x of portfolio funds in a risk-free security and 1 - x in
some portfolio g. If all funds are invested in the risk-free securitythat is, they are
loaned at the risk-free rate of interestthe result is the point Rf in Figure 1, a portfolio
with zero variance and a risk-free rate of return. Combinations of risk-free lending and
positive investment in g plot on the straight line between Rf and g. Points to the right of g
on the line represent borrowing at the risk-free rate, with the proceeds from the
borrowing used to increase investment in portfolio g. In short, portfolios that combine
risk-free lending or borrowing with some risky portfolio g plot along a straight line from Rf
through g in Figure 1.

E(R )

Mean-varianceeff cient frontier

with a riskless asset
Minimum variance

Frontier for risky assets



s (R )

Figure 1 showing portfolio or investment opportunities (Fama & French, 2004).


To obtain the mean-variance-efficient portfolios available with risk-free borrowing and

lending, one swings a line from Rf in Figure 1 up and to the left as far as possible, to the
tangency portfolio T. It can be determined that all efficient portfolios are combinations of
the risk-free asset (either risk-free borrowing or lending) and a single risky tangency
portfolio, T. This key result is Tobins (1958) separation theorem.
With complete agreement about distributions of returns, all investors see the same
opportunity set (Figure 1), and they combine the same risky tangency portfolio T with
risk-free lending or borrowing. Since all investors hold the same portfolio T of risky
assets, it must be the value-weight market portfolio of risky assets. Specifically, each
risky assets weight in the tangency portfolio, which we now call M (for the market),
must be the total market value of all outstanding units of the asset divided by the total
market value of all risky assets. In addition, the risk-free rate must be set (along with the
prices of risky assets) to clear the market for risk-free borrowing and lending.
The standard formula which describes the relationship between risk and expected
return:Ri = Rm + (Rm + Rf)
Where:Ri = required rate from company
Rm = market rate (all possible investments)
Rf = risk free rate of interest
= Slope coefficient of a regression line based on Ri and Rm.

CAPM is a model that provides a framework to determine the required rate of

return on an asset and indicates the relationship between return and risk of the

Professor Sharp hypothesis states that investors require higher rates of return for
greater levels of relevant risk. There are no prices on the model, instead it

hypothesizes the relationship between risk and return for individual securities.
The following assumptions are:
o Marker efficiency
o Risk aversion and mean variance optimization
o Homogeneous expectations
o Single time period
o Risk-free rate

The measurement of Rm with respect to ANSA MERCHANT BANK

Rm is the expected returns on the market as a whole. That is, it is the portfolio which
contains all available assets in proportion of their market weights. For this research project,
Rm was calculated by finding the average of all available assets in the Trinidad and Tobago
Stock exchange over a five year period from 2010-2014 for each year respectively (see
excel spreadsheets attached). The graph below shows the trend of the expected market
returns on the TTSE. This return could be in the form of profit through trading or in the form
of dividends given by the company to its shareholders as earnings per share.

Graph 1 showing market return trends over 5 year period

From the above graph it showed that there was a general decrease in market returns from
the year 2010 to 2011 followed by a sharp increase from 2011 to 2012. The returns on the
market was held constant from 2012 to 2013, however there was a sharp decline from the
year 2013 to 2014. Overall, the expected returns on the market did yield positive returns on
all possible investments, however, this was followed by negative returns in the year 2014.

The measurement of rate of return (Ri) from ANSA MERCHANT BANK

The required rate of return (RRR) is the rate that determines the potential return on
investment from a company. The required rate of return is also indicative of the minimum
return an investor should accept, given all options available and the capital structure of the
firm. The required rate of return (RRR) is used in both equity valuation and in corporate
finance. Potential investors compare the return of an investment to all other available
options, taking the risk-free rate of return, inflation and liquidity into consideration in their
calculation. For investors using the dividend discount model to pick stocks, the RRR affects
the maximum price they are willing to pay for a stock. The RRR is also used in calculations
of net present value in discounted cash flow analysis. The required rate of returns for ANSA
Merchant Bank was calculated by finding the average percentage rate of returns for each
year over a five year period.
The graph below shows the trend in the required rate of return for ANSA Merchant Bank over
the five year period 2010-2014.

Graph 2 showing trends of required rate of return for ANSA Merchant Bank over fve year period

From the above graph it showed that there was a sharp increase in the required rate of
returns from the year 2010 to 2011 followed by a sharp decrease from 2011 to 2012.
Thereafter, there was a general moderate increase in expected return from 2012 to 2013,
however there was a sharp decline from the year 2013 to 2014.

Graph 3 showing market return vs required rate of return by ANSA Merchant Bank over fve year period

Rm- market return

Ri-required rate of return by ANSA

The graph above showed a comparison between the market return vs the required rate of
return by ANSA Merchant Bank.
The measurement of Beta () for ANSA Merchant Bank
Beta is a measure of systematic (non-diversifiable) risk of an asset. It is reflected as a
coefficient and is expressed as a pure number which has no pure units of measure. There
are two fundamental methods of calculating the beta coefficient:
1. Using the formula (and subjective forecasts)
2. Use of regression (using past holding period returns)
In this report, the regression line method was utilized.
Beta is equal to the covariance of the returns of the stock with the returns of the market,
divided by the variance of the returns of the market. As shown in the formula below:

COVi,M i , M i

Beta is equal to the covariance of the returns of the stock with the

returns of the stock, with the returns of the market, divided by the variance of the returns of
the market. The graph below shows an example of how the beta coefficient was ascertained
using the regression line method:

Graph 4: ANSA Merchant Bank Securities market line for the year 2013

Ri for ANSA Merchant Bank

Linear (Ri for ANSA Merchant
f(x) = 0.35x - 0.01
R = 0.02

Graph 4 above shows a regression line generated between stock return (Ri) vs Market
return (Rm). The beta coefficient is found by the gradient of the line which was 0.349 for
ANSA Merchant Bank in the year 2013. Table 1 below shows beta for the five year period




Graph 5 showing trends of the beta coefficient for ANSA Merchant Bank

Interpretation of the beta coefficient

The beta of the market portfolio is always equal to one. The beta of a security compares the
volatility of its returns to the volatility of the market returns. The following are bench mark
interpretation of beta:
= 1.0 the security has the same volatility as the market as a whole
> 1.0 aggressive investment with volatility of returns greater than the market
< 1.0 defensive investment with volatility of returns less than the market.
< 0 an investment with returns that are negatively correlated with the returns of the
Over the five year period the average beta value was 0.08948. This indicated that the
volatility of the security returns from ANSA Merchant Bank was less volatile than the market.
This finding was also supported by the trends in graph 3; where the required rate of return
was generally less volatile than the market return. In other words investments for that period
were categorized as defensive investments.

The measurement of Rrf- risk free rate:

The risk free rate was measured base on The consistency principle with respect to cash
flows. According to Damodaran (2015), estimating risk free rates should be measured
consistently with how cash flows are measured. Thus, if cash flows are estimated in nominal
US dollar terms, then the risk free rate should be measured in US Treasury bond rate with
bonds maturing in ten years or more. Thus, base on the above statement, the risk free rate
was ascertained from the Trinidad and Tobago government bonds listed on the stock
exchange. The average rate was 5.15% over a ten year period.
A comparison of Ri based on the CAMP and actual return on the stock

Graph 6 showing Avgerate Ri vs Calculated Actural Ri for fve year period for ANSA Merchant Bank

Avg - Ri

Actual - Ri