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    Risk and Expected Return Standard Model (CAPM)

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    Isse Nvrro
    The document introduces the Capital Asset Pricing Model (CAPM) for tying risk and returns in pricing assets. It provides an example of how asset prices should adjust to equalize risk-reward ratios across all assets according to the CAPM. The example illustrates a process of how asset prices get priced and repriced in markets to satisfy the relationship proposed by the CAPM.

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    Risk and Expected Return Standard Model (CAPM)

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    Isse Nvrro
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    The document introduces the Capital Asset Pricing Model (CAPM) for tying risk and returns in pricing assets. It provides an example of how asset prices should adjust to equalize risk-reward ratios across all assets according to the CAPM. The example illustrates a process of how asset prices get priced and repriced in markets to satisfy the relationship proposed by the CAPM.

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    The document introduces the Capital Asset Pricing Model (CAPM) for tying risk and returns in pricing assets. It provides an example of how asset prices should adjust to equalize risk-reward ratios across all assets according to the CAPM. The example illustrates a process of how asset prices get priced and repriced in markets to satisfy the relationship proposed by the CAPM.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    25 views6 pages

    Risk and Expected Return Standard Model (CAPM)

    Uploaded by

    Isse Nvrro
    The document introduces the Capital Asset Pricing Model (CAPM) for tying risk and returns in pricing assets. It provides an example of how asset prices should adjust to equalize risk-reward ratios across all assets according to the CAPM. The example illustrates a process of how asset prices get priced and repriced in markets to satisfy the relationship proposed by the CAPM.

    Copyright:

    © All Rights Reserved
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    Download as pdf or txt
    of 6

    Introduction to Investments

    Risk and Expected Return Standard Model (CAPM) Prof S G Badrinath


    Tying Risk and Returns in Pricing Assets

    E(return)

    SML (CAPM)

    Risk (beta)

    • E(Rj) = Rf + [E(Rm)-Rf] * j = 2 + 6 j
    • Slope of line = 6 reward per unit risk
    • Intercept of line = risk free rate = 2%
    Introduction to Investments
    Where Does This Come From? Prof S G Badrinath
    Tying Risk and Returns in Pricing Assets

    Asset Current Price Expected Return Beta Risk/reward


    E(R) [E(R )- Rf]/Beta

    A 15 14% 1.5 6.67

    B 50 12% 1.0 8.00

    Rf 4% 0.0 0

    • For A, the expected return of 14% from current price levels implies an expected future price
    of 15 * (1.14) = $17.1
    • For B, expected return of 12% => expected future price of 50 * 1.12 = $56
    Introduction to Investments
    Case(i): Suppose B is priced correctly with a risk-reward of 8 Prof S G Badrinath
    Tying Risk and Returns in Pricing Assets

    • A is priced incorrectly. Investors will buy B, those owning A will sell it and move to B until A’s
    risk-reward is same as B.
    • A’s price will fall and its expected return will rise.
    • What expected return for A is consistent with a risk-reward of 8?
    • [E(R ) – 4]/1.5 = 8, E(R ) = 16% (increases)
    • What current price (based on future expected price of 17.1?
    • Current Price * (1.16) = 17.1, implies Current price for A = 14.74 (decreases from 15).
    • NOTE: This is a bit contrived to make the point, we have to keep something fixed!
    Introduction to Investments
    Case (ii): Suppose instead that A is priced correctly Prof S G Badrinath
    Tying Risk and Returns in Pricing Assets

    • Then B is undervalued and its price will increase to 50.601, its expected return will drop to
    10.67% and its risk-reward ratio will be 6.67. Confirm it!
    • Often, both can happen especially if the market risk-reward is 7 (say). The example
    illustrates a process of how assets get priced and repriced in markets.

    The message is that prices will (should) move this way to equate risk/reward ratios across all
    assets. Or, prices should be set so that the risk/reward ratio for all assets are equal.

    Here the risk-reward ratio has a specific form and using it,
    • [E(Rj) – Rf]/j = [E(Rm) – Rf]/1.0 = 8, Rearranging:
    • E(Rj) = Rf + j [E(Rm) – Rf] or the CAPM.
    Introduction to Investments
    Prof S G Badrinath
    Tying Risk and Returns in Pricing Assets

    In life, the risk-reward is probably more complicated than that assumed for the
    CAPM and other models for valuing assets exist.
    © All Rights Reserved.
    This document has been authored by Prof S G Badrinath and is permitted for use only within the course “Introduction to
    Investments" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
    illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
    electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.

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