Assignment of Security Analysis & Portfolio Management On Capital Asset Pricing Model

ASSIGNMENT OF SECURITY
ANALYSIS & PORTFOLIO

MANAGEMENT ON CAPITAL
ASSET PRICING MODEL
SUBMITTED TO: SUBMITTED BY:

PROF. HARPREET KAUR NAVEEN SHARMA
M.B.A II SEM 4th
th
ROLL NO. 12
THE CAPITAL ASSET PRICING MODEL (CAPM)
No matter how much you diversify your investments, some level of risk will always exist.
So investors naturally seek a rate of return that compensates for that risk. The capital asset
pricing model (CAPM) helps to calculate investment risk and what return on investment an
investor should expect.
Systematic Risk vs. Unsystematic Risk

The capital asset pricing model was developed by the financial economist (and later, Nobel
laureate in economics) William Sharpe, set out in his 1970 book Portfolio Theory and
Capital Markets. His model starts with the idea that individual investment contains two
types of risk:
1. Systematic Risk – These are market risks—that is, general perils of investing—that
cannot be diversified away. Interest rates, recessions, and wars are examples of
systematic risks.
2. Unsystematic Risk – Also known as "specific risk," this risk relates to individual
stocks. In more technical terms, it represents the component of a stock's return that
is not correlated with general market moves.
Modern portfolio theory shows that specific risk can be removed or at least mitigated
through diversification of a portfolio. The trouble is that diversification still does not solve
the problem of systematic risk; even a portfolio holding all the shares in the stock market
can't eliminate that risk.
The CAPM Formula

CAPM evolved as a way to measure this systematic risk. Sharpe found that the return on an
individual stock, or a portfolio of stocks, should equal its cost of capital. The standard
formula remains the CAPM, which describes the relationship between risk and expected
return.
Here is the formula:
Ra=Rrf+βa∗(Rm−Rrf)
where:Ra=Expected return on a security
Rrf=Risk-free rate
Rm=Expected return of the market
βa=The beta of the security
(Rm−Rrf)=Equity market premium
CAPM's starting point is the risk-free rate–typically a 10-year government bond yield. A

premium is added, one that equity investors demand as compensation for the extra risk they
accrue. This equity market premium consists of the expected return from the market as a
whole less the risk-free rate of return. The equity risk premium is multiplied by a coefficient
that Sharpe called "beta."
Beta's Role in CAPM

According to CAPM, beta is the only relevant measure of a stock's risk. It measures a
stock's relative volatility–that is, it shows how much the price of a particular stock jumps up
and down compared with how much the entire stock market jumps up and down. If a share
price moves exactly in line with the market, then the stock's beta is 1. A stock with a beta of
1.5 would rise by 15% if the market rose by 10% and fall by 15% if the market fell by 10%.
CAPM ASSUMPTIONS
The CAPM is often criticised as unrealistic because of the assumptions on which the model
is based, so it is important to be aware of these assumptions and the reasons why they are
criticised.
1. Investors hold diversified portfolios
This assumption means that investors will only require a return for the systematic risk of
their portfolios, since unsystematic risk has been diversified and can be ignored.
2. Single-period transaction horizon
A standardised holding period is assumed by the CAPM to make the returns on different
securities comparable. A return over six months, for example, cannot be compared to a
return over 12 months. A holding period of one year is usually used.
3. Investors can borrow and lend at the risk-free rate of return
This is an assumption made by portfolio theory, from which the CAPM was developed, and
provides a minimum level of return required by investors. The risk-free rate of return
corresponds to the intersection of the security market line (SML) and the y-axis (see Figure
1). The SML is a graphical representation of the CAPM formula.
4. Perfect capital market
This assumption means that all securities are valued correctly and that their returns will plot
on to the SML. A perfect capital market requires the following: that there are no taxes or
transaction costs; that perfect information is freely available to all investors who, as a result,
have the same expectations; that all investors are risk averse, rational and desire to
maximise their own utility; and that there are a large number of buyers and sellers in the
market.
While the assumptions made by the CAPM allow it to focus on the relationship between
return and systematic risk, the idealised world created by the assumptions is not the same as
the real world in which investment decisions are made by companies and individuals.
Real-world capital markets are clearly not perfect, for example. Even though it can be
argued that well-developed stock markets do, in practice, exhibit a high degree of efficiency,
there is scope for stock market securities to be priced incorrectly and so for their returns not
to plot onto the SML.
The assumption of a single-period transaction horizon appears reasonable from a real-world

perspective, because even though many investors hold securities for much longer than one
year, returns on securities are usually quoted on an annual basis.
The assumption that investors hold diversified portfolios means that all investors want to
hold a portfolio that reflects the stock market as a whole. Although it is not possible to own
the market portfolio itself, it is quite easy and inexpensive for investors to diversify away
specific or unsystematic risk and to construct portfolios that ‘track’ the stock market.
Assuming that investors are concerned only with receiving financial compensation for
systematic risk seems therefore to be quite reasonable.
A more serious problem is that investors cannot in the real world borrow at the risk-free rate
(for which the yield on short-dated government debt is taken as a proxy). The reason for this
is that the risk associated with individual investors is much higher than that associated with
the government. This inability to borrow at the risk-free rate means that in practice the slope
of the SML is shallower than in theory.
Overall, it seems reasonable to conclude that while the assumptions of the CAPM represent
an idealised world rather than the real-world, there is a strong possibility, in the real world,
of a linear relationship between required return and systematic risk.

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ASSIGNMENT OF SECURITY

ANALYSIS & PORTFOLIO

SUBMITTED TO: SUBMITTED BY:

Systematic Risk vs. Unsystematic Risk

The CAPM Formula

Here is the formula:

CAPM's starting point is the risk-free rate–typically a 10-year government bond yield. A

Beta's Role in CAPM

1. Investors hold diversified portfolios

3. Investors can borrow and lend at the risk-free rate of return

4. Perfect capital market

The assumption of a single-period transaction horizon appears reasonable from a real-world

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