CAPM Model
A model that describes the relationship
between risk and expected return that is used
in the pricing of risky securities.
The model was introduced by Jack Treynor,
William Sharpe, John Lintner and Jan Mossin
independently, building on the earlier work of
Harry Markowitz on diversification and
modern portfolio theory.
The general idea behind CAPM is that
investors need to be compensated in two ways:
time value of money and risk.
ASSUMPTIONS
Can lend and borrow unlimited amounts under the
risk free rate of interest.
Individuals seek to maximize the expected utility
of their portfolios over a single period planning
horizon.
Assume all information is available at the same
time to all investors.
The market is perfect: there are no taxes; there are
no transaction costs; securities are completely
divisible; the market is competitive.
The quantity of risky securities in the market is
given.
IMPLICATIONS AND RELEVANCE OF CAPM
Investors will always combine a risk free asset
with a market portfolio of risky assets.
Investors will invest in risky assets in
proportion to their market value.
Investors can expect returns from their
investment according to the risk. This implies
a linear relationship between the asset’s
expected return and its beta.
Investors will be compensated only for that
risk which they cannot diversify. This is the
market related (systematic) risk.
CAPM EQUATION
E(ri) = Rf + βi(E(rm) – Rf
Where;
E(ri) = return required on financial asset
i.
Rf = risk-free rate of return.
βi = beta value for financial asset i.
E(rm) = average return on the capital
market.
BETA
A measure of the volatility, or systematic risk,
of a security or a portfolio in comparison to the
market as a whole.
Beta is used in the capital asset pricing model
(CAPM), a model that calculates the expected
return of an asset based on its beta and
expected market returns.
Also known as "beta coefficient."
VALUE OF BETA
β= 1
β <1
β>1
For example, if a stock's beta is 1.2, it's
theoretically 20% more volatile than the
market.