CAPITAL ASSET PRICING

MODEL

Presented By:-
Karishma Indorewalla
Neha Jain
Vijayendra Rao
 Road Map

Assumptions Expected Assessing

Extensions &
duction & Return & Portfolio Shortcomings
Implications Risk Performance
 Introduction
 It is a set of predictions of the relationship between risk of an assets & its
expected returns .
 The model was introduced by Jack Treynor (1961, 1962), William Sharpe (1964),
John Lintner (1965) & Jan Mossin (1966) independently, building on the earlier
work of Harry Markowitz’s modern portfolio theory.
 It provides a benchmark rate of return for evaluating possible investments.
 It helps to make an educated guess on expected return on assets that are not yet
been traded in market place.
 In a nutshell CAPM helps us to calculate investment risk and what return on
investment we should expect.
Assumptions Of CAPM
 Risk averse individuals
 Price takers
 Efficient portfolios
 No tax or transaction costs
 Unlimited borrowing and lending at risk-free rate
 Homogeneous expectations
 Market equilibrium
 Investment in traded financial assets
 Information is costless and available to all investors
 One identical holding period
Implications
 All investors will hold a portfolio of assets in proportions that duplicate
representation of assets in the market portfolio
 Market portfolio will be on the efficient frontier
 Risk premium on the market portfolio will be proportional to its risk and
the risk aversion of the investor
 Risk premium on the individual stock will be proportional to the risk
premium on market portfolio and beta co-efficient
Expected Return And Risk

 CAPM describes three relations between expected return and risk:-

Capital
Market
Line
(CML)

Security
Market
Line (SML)
- Capital Market Line
 Linear risk-return trade-off for all investment portfolios
 Combination of Market Portfolio and Risk-free asset

Where
E (r_c) = the expected return on portfolio ‘c’
r (f) = the risk-free rate
Stdev (c) = the standard deviation of portfolio ‘c’
E (r_m) = the expected return on the market portfolio ‘m’
Stdev (m) = the standard deviation of the market portfolio ‘m’
Cont…
 -Capital Market Line (contd.)

Tangent line to the efficient frontier that passes through the risk-free rate on
the expected return axis.
- Security Market Line
 Similar to CML but for individual securities
 Systematic risk and unsystematic risk
 Only systematic risk has a favorable influence on E (Ri) – expected return
Portfolio Risk And CAPM

 Adding a stock to a portfolio changes its risk

 When 2 assets are combined, the new risk is the weighted average of their betas

βp = ∑i=1 to n wi * βi
Assessing Portfolio Performance
- Portfolio Characteristics
 Performance must always be viewed in relative to an appropriate benchmark

against other portfolios that have similar objectives & policies.

 Analyzing the characteristics is upmost important for assessing the

performance of a portfolio

 Long time period should always be considered

 Historical performance is also a useful guide to assess the portfolios

performance
- Alpha And Beta
Alpha
 Measure of performance on a risk-adjusted basis
 Abnormal return measured from CAPM required return
 One of five technical risk ratios
 If alpha>0 : Positive risk adjusted performance
 If alpha<0 : Underperformance of Portfolio

Beta

Beta Coefficient is the sensitivity of the asset returns to market returns

Systematic relation between risk premium and market
 Extensions Of CAPM
 Arbitrage Pricing Theory
- The exploitation of security mispricing in such a way that risk- free profits can be
earned is called arbitrage
- The theory was initiated by the economist Stephen Ross in 1976
- It a very simple model of security pricing with a underlying assumption that
investors prefer more wealth to less wealth
- APT model is never sure whether all the relevant risk are being accounted for but
it is useful in identifying what risk a firm is sensitive to
- The SML and CAPM are often contrasted with the arbitrage pricing theory (APT),
which holds that the expected return of a financial asset can be modelled as a
linear function of various macro-economic factors, where sensitivity to changes in
each factor is represented by a factor specific beta coefficient
Shortcomings Of CAPM
 Basic assumptions do not reflect real world scenario
- No taxes or transaction cost
- Homogenous expectations
- Information is costless and freely available to all

 Variance of returns is not an adequate measure of risk when the returns are
not normally distributed

Cont…
Is CAPM testable?
 Model tested in 2 ways:-
- Normative
- Positive

 CAPM implications are embedded in 2 predictions:-

- Market portfolio is efficient
- Alpha values are zero

 Testing of model is infeasible

 Conclusion
 This model presents a very simple theory that delivers a simple result. The

theory says that the only reason an investor should earn more, on average, by

investing in one stock rather than another is that one stock is riskier.

 The capital asset pricing model is by no means a perfect theory. But the spirit of

CAPM is correct. It provides a usable measure of risk that helps investors

determine what return they deserve for putting their money at risk.
Thank You…!!!