Capital Asset Pricing Model
CAPM tells how assets
should be priced in capital
markets
CAPM
Assumptions
•
Investors decisions are based on Risk and Return
relationship.
•
Investors can short sell Shares.
• Perfect competition exists in market viz. single person
cannot influence Market.
•
Investors Borrow or Lend Funds at a riskless rate.
•
Investors have identical expectations.
CAPM
• Investors
are
assumed
to
have
homogenous
expectations during the decision making period.
• Assets are infinitely divisible.
• There is no transaction cost i.e. no cost involved in
buying and selling of stocks.
• There is no personal income tax or Capital Gains Tax
Rate = Dividends Tax Rate
CAPM
If investors could borrow or lend any amount of money
at risk-less rate of interest they can combine risk free
assets with the risky assets in a portfolio to obtain a
desired rate of risk-return combination.
Rp = Portfolio return
Xf = Proportion of funds invested in risk free assets
1- Xf =Proportion of funds invested in risky assets
Rf = Risk free rate of return
Rm = Return of risky assets
CAPM
The Model
Rp = Rf Xf + Rm (1- Xf )
CAPM
0
σp
Rp
A
B
C
0
σp
Rp
S
Rf
CML
Efficient Frontier
Capital Market Line(CML)
CAPM
Ex-Ante RP derived
E(Rp) =
Rf + (Rm – Rf )
σm
σp
E(Rp) = portfolio’s expected rate of return
Rm
= expected return on market portfolio
σm
= standard deviation of market portfolio
σp
= standard deviation of the portfolio
Security Market Line
Ri – Rf =
[Rm – Rf]
σ2m
COVim
E(Ri) = Rf + βi[E(Rm) - Rf ]
SML
Y
X
Rp
Beta
Rf
Rm
S
1
SML
SML & Securities Evaluation
0.9
1.0
1.1
1.2
0
A
x
B
x
C
x
x
U
x
V
x
W
R
x
S
x
T
x
Beta
X
Rf
Rp
SML
Ri =
Pi - Po + Div
Po