Capital Asset Pricing Model

1
Capital Asset Pricing Model

• presented by
• Ryan Andrews and Amar Shah

2
Definition of CAPM

• Capital Asset Pricing Model
• States that the expected return on a specific
  asset equals the risk-free rate plus a premium
  that depends on the assets beta and the expected
  risk premium on the market portfolio.

3
Assessing Risk

• Two types of risk in securities
• Systematic Risk
• Unsystematic Risk
• Risk can be reduced but not eliminated
• Diversification

4
The Purpose of CAPM

• CAPM works to evaluate risk
• The equation says how much of return you should
  earn depending upon risk exposure

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CAPM Formula

• E(Rp) rf ßp (E(Rm) rf)
• E(Rp) Expected return on capital asset
• rf Risk-free rate of return
• ßp Sensitivity of the asset returns to market
  returns
• E(Rm) Expected return of the market

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Beta

• The measure of a particular stocks risk
• Relative Volatility
• Market behavior Beta of 1
• Higher than 1 Capital asset is more volatile
  than the market
• Lower than 1 Capital asset is less volatile than
  the market

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Security Market Line

• Use to construct a portfolio of T-Bills and
  market portfolio to achieve the desired level of
  risk and return

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Sample Problem Walkthrough

• Currently the risk-free rate equals 5 and the
  expected return on the market portfolio equals
  11. An investment analyst provides you with the
  following information
• Stock Beta Expected Return
• A 1.33 12
• B 0.7 10
• C 1.5 14
• Indicate whether each stock is overpriced, under
  priced, or correctly priced.

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Stock A

• E(Rp) rf ßp (E(Rm) rf)
• 5 1.33(11 - 5) 12.98
• 12.98 gt 12 so its underpriced

10
Stock B

• E(Rp) rf ßp (E(Rm) rf)
• 5 0.7(11 - 5) 9.2
• 9.2 lt 10 so its overpriced

11
Stock C

• E(Rp) rf ßp (E(Rm) rf)
• 5 1.5(11 - 5) 14
• 14 14 so its correctly priced

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Sample Problem

• A particular stock sells for 30. The stocks
  beta is 1.25, the risk free rate is 4, and the
  expected return on the market portfolio is 10.
  If you forecast that the stock will be worth 33
  next year (assume no dividends), should you buy
  the stock or not and what is the expected price?
• A.) Yes, it will be worth 33.45
• B.) Yes, it will be worth 35.00
• C.) No, it will be worth 32.50
• D.) No, it will be worth 30.00

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Solution

• E(Rp) rf ßp (E(Rm) rf)
• rf 4
• ßp 1.25
• E(Rm) 10
• E(Rp) ?
• Plug in numbers and solve for E(Rp)
• E(Rp) 4 1.25(10 - 4) 11.5

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Solution Cont.

• Use TVM functions on calculator to finish up the
  problem
• PV 30
• I/Y 11.5
• N 1
• PMT 0
• CPT, FV 33.45
• 33.45 gt 33, so buy this stock

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Conclusion

• CAPM predicts E(r) on a stock using the stocks
  beta, the risk-free rate, and the market risk
  premium
• Offers insight into the future, but not a
  guarantee
• Very useful, offers yet another way of investing
  safely