Finance School of management Chapter 13: The Capital Asset Pricing model Objective The theory of the CAPM Use of CAPM in benchmarking Using capm to determine correct rate for uesTc dis nting
1 Finance School of Management Chapter 13: The Capital Asset Pricing Model Objective •The Theory of the CAPM •Use of CAPM in benchmarking • Using CAPM to determine correct rate for discounting
Finance School of management Chapter 13 Contents 13. 1 The Capital Asset Pricing Model in Brief 13.2 Determining the risk Premium on the Market portfolio 13. 3 Beta and risk Premiums on Individual Securities 13.4 Using the CaPM in Portfolio Selection 13.5 Valuation regulating Rates of return uesTc
2 Finance School of Management Chapter 13 Contents 13.1 The Capital Asset Pricing Model in Brief 13.2 Determining the Risk Premium on the Market Portfolio 13.3 Beta and Risk Premiums on Individual Securities 13.4 Using the CAPM in Portfolio Selection 13.5 Valuation & Regulating Rates of Return
Finance School of management Introduction CAPM is a theory about equilibrium prices in the markets for risky assets It is important because it provides a justification for the widespread practice of passive investing called indexing a way to estimate expected rates of return for use in evaluating stocks and projects uesTc
3 Finance School of Management Introduction u CAPM is a theory about equilibrium prices in the markets for risky assets u It is important because it provides – a justification for the widespread practice of passive investing called indexing – a way to estimate expected rates of return for use in evaluating stocks and projects
Finance School of management The Capital Asset Pricing Model n brief CAPM is an equilibrium theory based on the theory of portfolio selection u The basic question What would risk premiums on securities be n equilibrium if people had the same set of forecasts of expected returns and risks and all chose their portfolios optimally according to the principles of efficient diversifications? uesTc
4 Finance School of Management The Capital Asset Pricing Model in Brief u CAPM is an equilibrium theory based on the theory of portfolio selection u The basic question What would risk premiums on securities be in equilibrium if people had the same set of forecasts of expected returns and risks and all chose their portfolios optimally according to the principles of efficient diversifications?
Finance School of management Assumptions of CAPM Assumption 1(homogeneous in information processing) Investors agree in their forecasts of expected rates of return, standard deviation, and correlations of the risky securities Assumption 2(homogeneous in behavior) Investors generally behave optimally according the theory of portfolio selection uesTc
5 Finance School of Management Assumptions of CAPM u Assumption 1 (homogeneous in information processing) Investors agree in their forecasts of expected rates of return, standard deviation, and correlations of the risky securities u Assumption 2 (homogeneous in behavior) Investors generally behave optimally according the theory of portfolio selection
Finance School of management Intuitive of capm All the investors will allocate their investments between the riskless asset and the same tangent portfolio In equilibrium, the aggregate demand for each security is equal to its supply The only way the asset market can clear is if the relative proportions of risky assets in tangent portfolio are the proportions in which they are valued in the market place, i. e. the market portfolio uesTc
6 Finance School of Management Intuitive of CAPM u All the investors will allocate their investments between the riskless asset and the same tangent portfolio u In equilibrium, the aggregate demand for each security is equal to its supply u The only way the asset market can clear is if the relative proportions of risky assets in tangent portfolio are the proportions in which they are valued in the market place, i.e. the market portfolio
Finance School of management The Capital Market Line(CML) CML Expected Return (%) M E(rm)-re Standard Deviation o uesTc
7 Finance School of Management The Capital Market Line (CML) Standard Deviation s Expected Return (%) CML rf M E(rM)- rf sM
Finance School of management Efficient risk-reward LE(M)-rfI E(r=r+ u In equilibrium, any efficient portfolio should be a combination of the market portfolio and the riskless asset u The best risk-reward depends on how much the market-related a portfolio bears uesTc
8 Finance School of Management Efficient Risk-reward s s M M f f E r r E r r [ ( ) ] ( ) − = + u In equilibrium, any efficient portfolio should be a combination of the market portfolio and the riskless asset u The best risk-reward depends on how much the market-related a portfolio bears
Finance School of management Determining the risk Premium on the Market portfolio The equilibrium risk premium on the market portfolio is the product of variance of the market weighted average of the degree of risk aversion of holders of risk. A E(M-r=AoM uesTc
9 Finance School of Management Determining the Risk Premium on the Market Portfolio u The equilibrium risk premium on the market portfolio is the product of – variance of the market, s2 M – weighted average of the degree of risk aversion of holders of risk, A 2 ( ) M f A M E r −r = s
Finance School of management Example: To Determine A E(M)=0.14,M=0.20,7=006 E(r)-r=Aa→sb(m)-r 2 M 0.14-0.06 2.0 0.202 uesTc 10
10 Finance School of Management Example: To Determine ‘A’ 2.0 0.20 0.14 0.06 ( ) ( ) ( ) 0.14, 0.20, 0.06, 2 2 2 = − = − − = = = = = A E r r E r r A A E r r M M f M f M M M f s s s