Capital Asset Pricing Model (CAPM)
Diversification reduces risk to a certain extent
Even after the potential diversification benefit is exploited
fully, certain amount of risks remain
Otherwise, diversification would have reduced the risk of a
portfolio of risky assets to zero!
This portion of risk may be termed as unavoidable risk
An equilibrium relationship between risk and expected return
exists
(Claimed by CAPM)
In equilibrium, a security is expected to generate return
commensurate with its unavoidable risk
This will be true under a set of assumptions:
CAPM - Assumptions
The assumptions are:
Free information, and investors are well-informed
Transaction costs and taxes are absent
No restriction on investment (near complete markets)
Investors agree about expected return and risk of individual
securities
Investors have common holding period
Consider two assets:
A risk-free asset (usually a treasury bill)
A market portfolio (proxied by an index based on a large
no. of stocks)
Characteristic Line 1
For any individual security/ portfolio of securities:
Excess return = Expected return Risk-free return
The excess return for the market portfolio may be obtained similarly
(by using the market index)
Main concern is: what is the relation between excess return on the
individual stock and that on the market portfolio?
The relationship is usually estimated using historical data
Assuming past data would be a good approximation of future
Characteristic Line
Alpha
Systematic (Non-diversifiable/ unavoidable) Risk and Beta
Unsystematic (diversifiable/ avoidable) Risk
Characteristic Line 2
These parameters are estimated by using normally two techniques
Geometrical (or Graphical) (See the calculation in Excel)
Or analytical, by running the following regression:
Ri Rf = i + i(Rm Rf) + i
Characteristic Line (See the calculation in Excel)
Alpha
Systematic (Non-diversifiable/ unavoidable) Risk and Beta
Unsystematic (diversifiable/ avoidable) Risk
Capital Asset Pricing Model (CAPM) Alpha
Alpha:
It is simply the intercept term
It is the return from the stock when return from market
portfolio is zero
In theory it should be zero
In practice, often it is not zero
Alpha = 2.2% means the security would yield 2.2%
return even when the market return is zero
Alpha = - 2% similarly means
Low beta stocks tend to have +ve alphas, and high-beta
stocks tend to have ve alphas
CAPM Beta and Systematic Risk - 1
Beta:
It is the slope of the Characteristic Line
Measures the sensitivity of excess return on the stock to
that on the market portfolio
It is a measure of unavoidable or systematic risk, that
comes from the market
beta = 1 for a stock when ER of the market is 1%, the
ER of the stock is also 1% (as risky as the market)
Beta <1 change in the market of 1% leads to less than
1% change in the price of the stock (less risky than the
market)
CAPM Beta and Systematic Risk - 2
Beta:
Similarly for beta >1, ER of the stock is more than the ER
on the market portfolio
True for both upward & downward movements
All the above are true in an average sense
Portfolio Beta = weighted average betas of individual stocks
CAPM Unsystematic Risk 1
Unsystematic Risk
It is the variability of the stocks return not associated
with the market
Measured by the distances of the individual points from
the Characteristic Line
It is this portion of the total risk that can be minimized by
diversification
Beta and Diversifiable Risk
Total Risk = Market Risk + Diversifiable Risk
i2 = 2 M2 + i2
CAPM Unsystematic Risk 2
The fundamental principle of Higher risk must be
compensated by higher expected return is to be interpreted
as follows:
Since unsystematic risk can be diversified away, this risk
is not priced
That is, investors are not rewarded with higher
expected return for bearing unsystematic/ diversifiable
risk
Investors are rewarded with higher expected return only
for bearing the systematic risk (measured by beta)
Expected Return of a Stock
Expected (Required) Return of a Stock
Beta is used to estimate the expected/required return of a stock
It is given by:
E[Rj] = Rf + j (Rm Rf)
For example:
If, beta of ITC is 1.25, Rf = 4.5%, and the stock market is
expected to yield a return of 12% per annum over the next
year, then the expected return from ITC stock is
= 4.5% + 1.25 (12%) = 19.5%
Securities Market Line (SML) 1
Security Market Line (SML)
Consider the following equation for the required return of an
individual stock (say, i-th sock)
Required Return = Rf + (Rm Rf)
Consider two stocks A & B, with A being more risky than B.
If Rf=6%, Rm=12%, then A must have higher required return than
B
If Bs beta is 1.2, then As beta must be higher than 1.2, say 1.5.
RR(B) = 6% + 1.2 (12% - 6%) = 13.2%;
RR(A) = 6% + 1.5 (12% - 6%) = 15%
Securities Market Line (SML) 2
Security Market Line (SML)
Now consider all the securities in the market, their
individual betas and expected returns
Now plot betas on the horizontal axis and expected returns
on the vertical axis
Under the assumptions of CAPM, when the market is in
equilibrium, what you get is the
SECURITIES MARKET LINE (SML)
The SML
Expected Return ER of the security is more than what the
market offers for a similar risk in this zone
P
Above SML:
Zone of Under-
valuation
Rm Risk Premium
Below SML:
Zone of Over-
valuation
Rf
Risk-free Return
= 1.0 Systematic Risk (beta)
Issues with CAPM - 1
Maturity of Risk Free Rate
For the risk-free rate, Treasury bills/ government securities
to be used
But of which maturity?
Shorter-maturity (say 91-day) rates are usually lower than
longer-maturity (say 3 or 5 years) rates
The answer depends on the purpose for which beta is
calculated
For portfolio investment, use of return on 91-day TB is
suggested
For capital budgeting purposes, use 1/3/5 year rates on
TB/G-secs is suggested
Issues with CAPM - 2
Equity Premium (Rm Rf)
Market return over and above the risk-free rate is known as
Equity Premium
In the past 3 decades, equity premium in India has been
about 8% per annum (on average basis)
Though past premium helps, but expected premium(future)
is not the same as past equity premium
Currently analysts agree that expected return from equities
in India over next 5 years is 12% - 15%
Assuming a risk-free rate of 5% (current yield on 91-day
treasury bills), the expected equity premium is 7% - 10%
Issues with CAPM - 3
Use of Market Index
Remember, we are talking about market return that is,
return on all equities listed in the market
But major indices (like Sensex or Nifty-50) consist of 30-
50 stocks
Although these account for close to 90% of entire market
capitalization and market turn-over, still there are issues
Small-cap gives higher returns than large-caps
Differences in sectoral performance are likely to persist
Issues with CAPM - 4
Fama-French Onslaught
CAPM argues that beta captures the entire systematic risk
Empirical studies have found that apart from beta, size
(measured by market capitalization), book-to-market ratio,
etc. are also important predictor of stock returns
Fama & French have proposed a three-factor model, where
Factor 1 is the market return itself (as is done in CAPM
beta)
Factor 2 is the return on size-related factors (Small-
minus-big)
Factor 3 is return on book-to-market related factors
(High-minus-low)
Issues with CAPM - 5
Fama-French Onslaught
Empirical evidence across countries show that FF model is
capable of explaining over 90% of a stocks return,
As opposed to only about 40%-50% by CAPM
Debate is going on