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CAPITAL SECURITY
INVESTMENT RETURNS RISKS ASSET MARKET
PRICING LINE (SML)
MODEL
Fixed Income Stand-Alone Risk (CAPM)
Change in
Variable Special Metric: Coefficient SML due to
Income of Variation Behaviour
Expected Rate
of Return Risk Aversion and Risk
Premium Change in
Required Rate SML due to
of Return Inflation
Portfolio Risk
Actual Rate of
Return Risk in a Portfolio Context
Market Rate
Returns in a Portfolio
of Return
Context
INVESTMENT
Overview of Investment in a single asset
or Stand-Alone Investments
RETURN (Stand-alone or Single asset)
return = 7% + 5% + 10% + 8% + 9%
5
return = 7.8%
Case 3: Variable income (probability-based)
Mr. D purchased a stock of Elepanto Consolidated Mining Corp. which
provided, in its prospectus, a pay-off table of the amount of return
expected in a given market condition for copper which is its prime product.
The pay-off table is as follows:
Return on particular
Demand for copper Probability of demand
demand
High (> 10 billion metric tons) 18% 20%
Normal (5-10 billion metric tons) 12% 50%
Low ( <5 billion metric tons) 8.7% 30%
Case 3: Variable income (probability-based)
Market Equilibrium
Expected Rate of Return
Market Equilibrium
Expected Rate of Return
Market Equilibrium
Expected Rate of Return
Market Equilibrium
The event when the required rate of return is equal to
the expected rate of return on an investment.
Risks (Stand-alone or Single asset)
Risk involves a probability of loss on the part of the investor. The losses incurred
are actually manifestations of risk.
While several measures of risk are available, the standard deviation is one of the
primary tools by financial managers in determining the level of risk.
For example:
Security A increased its return by 10% while Security B
decreased its return by 10%.
RETURNS IN A PORTFOLIO CONTEXT
Return in a portfolio context is not at all difficult; it is
simply the weighted average of all the returns of each type
of security.
CAPM simply wants to put a security’s risk as the only variable in the model.
Before we provide the mathematical model, we must
first identify the components needed:
r = the required return of a particular security
rf = refers to the risks-free rate of return or the return of the riskless
security
rm = refers to the market return or the overall return of the whole
market containing all the “risky” and “non-risky” securities
MRP = refers to the market risk premium or the excess return provided
by the market as a premium for having “risky” securities
β = Beta – this is the measure of the riskiness of security. It also
measures the responsiveness of a particular security with the
fluctuations of returns in the market.
Formula for the CAPM:
r = rf + β (rm - rf )
r = rf + β (MRP)
r = rf + β (rm - rf )
r = 4% + 1.0 (10% - 4% )
r = 4% + 1.0 (6% )
r = 10%
Case 2: Beta is below 1.0 (Defensive or Conservative Beta)
Company B recently acquired the shares of ABBA Equity Ventures with a Beta of
0.8. It wishes to determine the required return of such particular stock. The
government Treasury Bills yield 4%. On the other hand, the prevailing market
return is 10%
r = rf + β (rm - rf )
r = 4% + 0.8 (10% - 4% )
r = 4% + 0.8 (6% )
r = 8.8%
Case 3: Beta is above 1.0 (Aggressive Beta)
Company C recently acquired the shares of Carcamo Corporation with a Beta of
1.5. It wishes to determine the required return of such particular stock. The
government Treasury Bills yield 4%. On the other hand, the prevailing market
return is 10%
r = rf + β (rm - rf )
r = 4% + 1.5 (10% - 4% )
r = 4% + 1.5 (6% )
r = 13%
The Security Market Line (SML)
r = rf +FORMULA
β (rm - rf )
Illustrative Problem 4-3
Previously, the Treasury bills yield 4% while the market return is at 10%.
Currently, the investors believe that due to expected inflation, the risk-free
rate of return should be pegged at 6% rather than 4%.