Module II
Capital Asset Pricing Model
Points to be Discussed
Sharpe Ratio
Capital Market Line (CML)
Security Market Line (SML) OR CAPM
Capital Asset Pricing Model – William Sharpe and Others
Essentially, the capital asset pricing model (CAPM) is concerned
with the question:
What is the relationship
between risk and return
for an individual security?
INPUTS REQUIRED FOR
APPLYING CAPM
Risk-free return
• Rate on a short-term govt security
• Rate on a long term govt bond eg. 364-day T-bill rate
Market risk premium
• Difference between the average return on Market and the average
risk - free return
Beta
• The sensitivity of the security’s return to the market’s return
Estimation issues with Beta
Estimation Period
• A longer estimation period may give more data, but the risk profile of
the firm may change over time. Hence analysts regard 5 year period to
be reasonable
Return Interval
• Returns may be calculated on an annual, monthly, weekly or daily
basis. Analysts prefer weekly or monthly returns
Market Index
• Generally Nifty index is estimated as the index of the market
Sharpe Ratio
Slope
Difference between CML and
SML
• CML stands for Capital Market Line, and SML stands for Security
Market Line.
• The CML is a line that is used to show the rates of return, which
depends on risk-free rates of return and levels of risk for a specific
portfolio.
• SML, which is also called a Characteristic Line, is a graphical
representation of the risk and return for specific stock.
• Standard deviation is the measure of risk for CML, Beta coefficient
determines the risk factors of the SML.
• CML measures the risk through standard deviation, which is total risk
factor. SML measures the risk through beta, which is only systematic
risk.
• The Capital Market Line is considered to be superior when
measuring the risk factors and determining efficient portfolio.
Relationship Between Risk and Return
Return
(Expected) High
Low Average Risk Security Market
Risk Risk Line (SML)
The slope of SML indicates
required return per unit of risk
NRFR
(Risk Premium)
Risk
(Systematic Risk)
Three Possibilities of change in SML
• Movement along the SML
• Change in the slope of SML
• Shift in SML
Movement Along the SML
• If an investment’s return changes due to a change in one
of its risk sources, it will move along the SML
• For e.g. if a firm increases its financial leverage, investor
will perceive its stock as more riskier and will move up
on SML demanding more return
Changes in the Required Rate of Return
Due to Movements Along the SML
Expected
Rate
Security
Market Line
Movements along the curve
that reflect changes in the
RFR risk of the asset
Risk
(business risk, etc., or systematic risk-beta)
Changes in the Slope of the SML
• The slope of SML indicates the return per unit
of risk required by all investors
• Risk Premium:
RPi = E(Ri) - NRFR
where:
RPi = risk premium for asset i
E(Ri) = the expected return for asset i
NRFR = the nominal return on a risk-free asset
Changes in the Slope of the SML
• The slope of SML can change because of change
in attitude of investors towards risk and relevant
return
• That is when all the investors changes the return
they require per unit of risk (Same unit of risk)
Change in Market Risk Premium
Exhibit 1.10
E(R)Return
Expected
New SML
Rm'
Rm2´
Original SML
Rm1
Rm
NRFR
RFR
Risk
Shift in SML
• There will be a parallel shift in SML when in case
of change in,
• Real growth in economy
• Capital Market Conditions
• Expected rate of inflation
Capital Market Conditions,
Expected Inflation, and the SML
Rate of Return
Expected Return
New SML
Original SML
RFR'
NRFR
NRFR
RFR
Risk
Arbitrage Pricing Theory Model
Claims that Challenges exist with CAPM Model
What happens if many factors are required to specify the
relationship between risk and return?
Beta of a stock may change over time
Historical beta may not always forecast the expected returns
accurately
Arbitrage Pricing Theory Model
Historical return will be different from the expected
return
It incorporates any number of risk factors
For eg. Market return may be influenced by factors
like GDP, inflation level, investor sentiment and so on
The expected rate of return on
a stock is as per APT model is:
E(ri) = rf + βi1 * RP1 + βi2 * RP2 + ... + βkn * RPn
where rf is the risk-free rate of return,
β is the sensitivity of the asset or portfolio in relation to the
specified factor and
RP is the risk premium of the specified factor.
Empirical evidence of APT
• Unlike CAPM, APT does not specify a
priori what will be the underlying risk
factors
• APT uses multivariate techniques to
derive the number of factors and then
applies the model
Multifactor Model
• Given the practical difficulties is using APT
model, multifactor model has been developed
where the researcher chooses the exact number and
identity of risk factors a priori
• Researcher may choose macroeconomic risk
factor model
• Or microeconomic risk factor model
Limitations of Multifactor model
• It explains the past returns better
• But when it comes to predicting the expected returns, the results are
ambiguous
• The gains from having multiple factors are offset by the errors
committed in estimating them and factor betas
• Hence the widespread use of CAPM model stems from its simplicity
and intuitive appeal