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CAPM-Capital Assets Pricing Model

The capital asset pricing model (CAPM) is used to calculate the required rate of return for
any risky asset. Your required rate of return is the increase in value you should expect to see
based on the inherent risk level of the asset

CAPM is builds on the model of portfolio choice developed by Markowitz (1959).


Markowitz model suggest that an investor select a portfolio at time t-1 that produce a
stochastic return at time t. The model assume that investors are risk averse when choosing
among portfolio, they care about the mean and variance of their One-Period Investment
return.
The theory also says that investors can combine different assets to minimize risk and
maximize return to make an efficient portfolio.
Assumption
Investor is supposed to be risk averse, he wants a small variance (small risk) and high
return. So Markowitz model is called Mean-Variance Model.
Sharpe (1964) and Litner (1965) added two more assumption to the Markowitz model:
1. Compete Agreement: investors agree on the joint distribution of assets return from t-1
to t. i.e. say one year.
2. Borrowing and lending at risk free rate of return.
CAPM says
The CAPM says that the expected return of a security or a portfolio equals the rate on a riskfree security plus a risk premium. If this expected return does not meet or beat the required
return, then the investment should not be undertaken. The security market line plots the
results of the CAPM for all different risks (betas).
Using the CAPM model and the following assumptions, we can compute the expected return
of a stock in this CAPM.
Assumptions of CAPM
1.
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7.

Capital market are efficient i.e. investors are well informed


No Transaction cost or taxation cost.
No investor is large to affect the market prices of stocks.
Investors are rational and risk-averse.
Investors can short any asset, and hold any fraction of an asset
Investors hold diversified portfolio i.e. systematic risk, not unsys
Investors can borrow and lend at risk free rate of return

8. Also assume that investors are on general agreement and them likely performance of
individual securities and their expectations are based on a common holding period
one year.
There are two types of investment opportunities:
Risk Free security whose return over the holding period is known with

certainity.
Market portfolio of common stocks. It represented by all available common
stocks and weighted of their aggregate market value outstanding.

Arbitrage Pricing Theory (APT)


Ross (1976) proposed the Arbitrage Pricing Theory (APT) where stock returns were
presented as a function of multiple risk factors. These risk factors include GDP, interest rates,
inflation and so on. In contrast, CAPM relies on only a single factor i.e. the relative risk.
Fama and French (1992), evaluated the effects of beta, size, E/P ratio, financial leverage
and Book-to-Market Equity ratio on the stock returns of various American stocks. They
found that the conventional risk-return relationship, as proposed by CAPM, failed to hold for
the period 1963 1990 even when univariate tests were performed.
However, all other variables were found to be statistically significant and displayed expected
results in univariate tests for each variable. This research lead to the FamaFrench three
factor model by Fama and French (1993) which introduced 2 more variables in addition to
beta; the size represented by market capitalization and book-to-market value ratio.
Criticism on CAPM
The CAPM have come under quite a few criticisms over time. The size and P/E ratio also
affect average returns in addition to beta.
Basu (1977) found that stocks with low P/E ratios outperformed those with high P/E ratios.
Banz (1981) the stocks of firms with low market capitalizations have higher average returns
than large capitalization stocks. These two contradictions are not connecting and small firms
tend to have higher returns, even after controlling for E/P.
DeBondt and Thaler (1985) find that those stocks that have had poor returns over the past
three to five years have much higher average returns than winners over the next three to
five years. Chopra, Lakonishok and Ritter (1992) show that beta cannot account for this
difference in average returns. And there is not exist such beta able to justify the return
difference and so the CAPM.

Bhandari (1988), concluded that the leverage variable, as a function of average returns, apart
from size and beta. High leverage increases the riskiness of a firms equity, but this increased
risk should be reflected in a higher beta coefficient.
Jegadeesh and Titman (1993) confirms these results. Their study also indicates that the
momentum is stronger for firms that have had poor recent performance
How to Calculate Beta
Beta is a measure used in fundamental analysis to determine the volatility of an asset or
portfolio in relation to the overall market. To calculate the beta of a security, the covariance
between the return of the security and the return of market must be known, as well as the
variance of the market returns.
The formula for calculating beta is the covariance of the return of an asset and the return of
the benchmark divided by the variance of the return of the benchmark over a certain period.
Beta= Covariance (ri,rm )/Variance of Market
Similarly beta can be calculated security's standard deviation of returns by the benchmark's
standard deviation of returns. The resulting value is multiplied by the correlation of the
security's returns and the benchmark's returns.
Beta= Correlation (ra,rm)* S.D(i)/ S.D(m)

CAPM calculation for a Company:


Cost of equity refers to a shareholder's required rate of return on an equity investment. It is
the rate of return that could have been earned by putting the same money into a different
investment with equal risk.
Cost of equity can be calculated using two methods:
1. Dividend Growth Model:
Ke= Next year Dividend/Current Stock price + Dividend Growth Rate
2. Capital Assets Pricing Model CAPM
Cost of Equity = Risk-Free Rate + Beta * (Market Rate of Return - Risk-Free Rate)
ra = rf + Ba (rm-rf)
Let's assume the following for a Company
Next year's dividend: $1
Current stock price: $10

Dividend growth rate: 3%


rf: 3%,
Ba: 1.0,

rm: 12%

Using the dividend growth model, we can calculate that Company XYZ's Cost of Capital is
($1 / $10 ) + 3% = 13%
Using CAPM, we can calculate that Company XYZ's cost of capital is 3% + 1.0*(12% - 3%)
= 12%