Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM)
CAPM is a model that describes the relationship between risk and required return
in this model
a security’s required return =the risk-free rate +a premium based on the systematic risk of the security
CAPM Assumptions
1. Capital markets are efficient.

2. Homogeneous investor expectations over a given period.
3. Risk-free asset return is certain (use short- to intermediate-term Treasuries as a proxy). Risk free =real interest
rate + inflation premium.
4. Market portfolio contains only systematic risk.
The Capital Asset Pricing Model (CAPM) equation

The equation is, a straight-line equation y= a + bx
Where, a intercept of the function b  the slope of the line, x the value of the independent
variable on the x-axis.
Substituting (ri)y variable, (dependent)
rf  intercept a,
(rm - rf) the slope
β independent variable on the x-axis, we have the formal equation for the SML:
ri = rf + (rm - rf) βi
Note: the slope of the SML is the market risk premium, i.e. (rm - rf),
Ri is the required rate of return for stock i or a portfolio, “dependent variable”
Rf is the risk-free rate of return,
bi is the beta of stock i or a portfolio (measures systematic risk of stocki), “independent variable”
RM is the expected return for the market portfolio.
{RM – Rf } is the market risk premium which is the slop of SML “constant”
The Security Market Line and the CAPM (cont.)

The straight line relationship between the betas and required returns is called the security market line (SML)
• SML is a graphical representation of the CAPM.

• SML specifies the linear relationship between required return and risk (systematic only) of any stock or portfolio
• SML is used to determine whether the stock is underpriced (should be bought) or overpriced (should be sold)
there are two important relations depending on the position of the expected return of the stock compared to the SML:
1) If the expected rate of return is higher than the rate of return estimated by SML, then the expected return of the
stock is above the SML. Which meant that the stock is underpriced
2) If the expected rate of return is lower than the rate of return estimated by SML, then the expected return of the stock
is below the SML. Which meant that the stock is overpriced or overvalued
Example (1): The Capital Asset Pricing Model (CAPM) (continued)

Finding Required Returns for a Company with Known Beta Problem The New Ideas Corporation’s recent strategic
moveshave resulted in its beta going from 0.8 to 1.2. If the risk-free rate is currently at 4% and the market risk premium
is being estimated at 7%, calculate its required rate of return.
Solution
Using the CAPM equation we have:
ri = rf + (rm - rf )  βi
where
Rf = 4%; rm - rf = 7%; and β = 1.2
Required rate of return = 4% + 7%*1.2 = 4% + 8.4 = 12.4%
Assessing Market Attractiveness Problem
• Let’s say that you are looking at investing in 2 stocks, A and B.
• A has a beta of 1.3 and, based on your best estimates, is expected to have a return of 15%,
• B has a beta of 0.9 and is expected to earn 9%.
• If the risk-free rate is currently 4% and the expected return on the market is 11%, determine whether these stocks are worth
investing in. solution
Ri = Rf + { RM – Rf } × bi
Stock A’s required return = 4% + (11% - 4%) * 1.3 = 13.1%
Stock B’s required return = 4% + (11% - 4%) * 0.9 = 10.3%
So, Stock A would plot above the SML since 15%>13.1% and would be considered undervalued, while stock B would plot
below the SML (9%<10.3%) and would be considered overvalued
Factors that change the SML
First: Changes in Inflation Expectation What if investors raise its inflation expectations by 3%, what would happen to the
SML ?
Using the following information of a stock: rf = 5.5%; rm = 10.5%; and β = 1
Required rate of return= 5.5% + (10.5% - 5.5%)*1 = 5.5% + 5%= 10.5%
After increase in inflation both rf and rm will increase and required rate of return will increase
Second : After increasing risk aversion, rf = 5.5% ( will not be affected) rm = 10.5% + 3% = 13.5% (rm - rf ) = 13.5% - 5.5% = 8% β
=1
- Required rate of return= 5.5% + 8%*1= 5.5% + 8% = 13.5%

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Capital Asset Pricing Model (CAPM)

1. Capital markets are efficient.

The Capital Asset Pricing Model (CAPM) equation

The Security Market Line and the CAPM (cont.)

• SML is a graphical representation of the CAPM.

Example (1): The Capital Asset Pricing Model (CAPM) (continued)

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