CAPITAL ASSET PRICING MODEL

Presented by: Shajeer Sainudeen Lecturer, Villa International College, Maldives

Why CAPM

Fair price/Equilibrium price of an asset Market price Comparison between FP and MP Purchase/Sell the asset

Asset Pricing Models helps to find out the fair price of different assets….

CAPITAL ASSET PRISING MODEL

How does it work? Example: Consider the fair price of share A is mvr 10 Think of the actions taken by investors in the following situations….. 1. The MP of A raises up to 12 2. The MP of A comes down to 9 What we can conclude??? Is fair price a price to buy or sell???

Assumptions of CAPM

Investors can borrow and lend any amount at a fixed, “risk-free” rate. That is rB = rL = rf

rL – rB is called ‘spread’ Investors pay no taxes on returns and no

transaction costs (commissions and stamp duties)

Homogeneous expectation

Market portfolio return

The market portfolio is a portfolio of all risky securities held in proportion to their market value Where,

vi = total dollar value of security i

total dollar value of all risky securities

rM is the return on market portfolio ri is the return of security i

Market risk premium/ Expected excess return

The market risk premium is simply defined as the difference between the return on the market portfolio and the return on the risk-free investment. Market Risk Premium = E(rM)- rf If the expected return of market portfolio A is 10% and the return from Maldivian bank is 5%, the how much will be the risk premium? Individual Risk premium/ Expected excess return Individual Risk Premium= E(ri)- rf

Expected Return on Individual Stock

The relationship between market risk premium and individual risk premium can be related as the following… E(ri) – rf = βi[E(Rm) – rf] E(ri) = rf + βi[E(Rm) – rf] β Coefficient is the rate of systematic risk associated with an individual stock. Ex-ante version: E(ri) = rf + βi[E(Rm) – rf] Based on future estimation Ex-post version: ri = rf + βi[Rm – rf] Based on historical data

Security Market Line

If we put the linear equation obtained through CAPM into a graph, we will get a straight line. It is called as Security Market Line(SML)

Can we draw one Security Market Line? For that, you can make use of your first tutorial question.

Investment Decision making process

What about the points below and above the SML? Which one gives more return? Which one gives less? Which is over priced and under priced?

Finding beta value through regression

Here the ‘αi’ (alpha) is considered as the difference between expected excess return and actual excess return of an individual stock.

rit - rft = Excess rate of return on individual stock i at time t. rMt - rf = excess rate of return on market portfolio or the market risk premium at time t. αi = Alpha coefficient in the regression at time t. βi = is the beta coefficient in the regression, the measure of systematic risk at time t.

εit = The error terms of the regression at time t.

Systematic Risk(β)

( Beta value of individual asset)

βi= Cov(ri,rM)/Var(rM) Where, Cov(ri,rM) is the covariance between returns of individual stock and the market portfolio. Var(rM) is the variance of the market portfolio ( Beta value of Market portfolio) The beta value of MP is always 1 βM = Cov(rM,rM)/Var(rM) = Var(rM)/Var(rM) = 1 ???? What would be the individual asset preferred by an investor. ???? With βi>1 or βi<1 ??

What is aggressive investment?? And what is defensive???

CAPM for a portfolio

rP = rf + βP(rM – rf) Where, rP is the equilibrium rate of return of a portfolio βP is the portfolio beta βP= ∑ βi wi Wi is the weight assigned to each individual assets. Tutorial 3 will help us to know more about this….. Is there any stability problem with beta coefficient???????

The relaxation of CAPM assumptions

1.Borrowing late is more than lending rate rB>rL E(ri) = rB +βi(rM – rB) E(rj) = rL +βj(rM – rL)

2. Commissions and charges are taking into consideration. Put a band along….. 3. Incorporate taxes into CAPM 4. Eliminating the assumption of homogenous expectations.

THANK YOU