C.A.P.M Flashcards
What is C.A.P.M.
Capital Asset Pricing Model (C.A.P.M.) describes the relationship between systematic risk and expected return for assets.
C.A.P.M. is widely used throughout finance for the pricing of risky securities, generating expected returns for assets given the risk of those assets and calculating costs of capital.
Systematic risks are market risks that cannot be diversified away.
C.A.P.M. General concept
Investors need to be compensated in two ways:
- Time value of money
- Risk
The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time.
C.A.P.M. Risk Free Rate
Risk-free rate for CAPM is typically the yield on government bonds, typically U.S. Treasuries.
C.A.P.M. Risk
The C.A.P.M. formula calculates the amount of compensation the investor needs for taking on additional risk.
This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium.
Market Premium (Rm-rf) = The return of the market in excess of the risk-free rate.
Beta reflects how risky an asset is compared to overall market risk and is a correlation between the two.
For stocks, the market is usually represented by the FTSE 100 or S&P 500 but can be represented by more robust indexes as well.
C.A.P.M. and BETA
According to CAPM, beta is the only relevant measure of a stock’s risk.
It measures a stocks volatility relative to the market.
BETA
BETA measures a stock’s relative volatility.
It shows how much the price of a particular stock moves relative to the stock market as a whole.
Beta is found by statistical analysis of individual, daily share price returns, in comparison with the market’s daily returns over precisely the same period
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%.
BETA
Beta, compared with the equity risk premium, shows the amount of compensation equity investors need for taking on additional risk.
Stock A - BETA 2.0, Risk Free Rate 3% and Market Return 7%.
Markets excess return = 4% (7% - 3% = 4%).
Stocks excess return = 8% (4% x 2 = 8%).
Stock’s total required return = 11% (8% + 3% = 11%)
Equity Risk Premium
Equity risk premium refers to the excess return that investing in the stock market provides over a risk-free rate.
This excess return compensates investors for taking on the relatively higher risk of equity investing.
The size of the premium varies depending on the level of risk in a particular portfolio and also changes over time as market risk fluctuates.
As a rule, high-risk investments are compensated with a higher premium.
C.A.P.M. History
The capital asset pricing model was the work of financial economist William Sharpe.
Individual investment contains two types of risk:
Systematic Risk
Unsystematic Risk
Systematic Risk
These are market risks that cannot be diversified away.
Interest rates
Recessions
Wars
Unsystematic Risk
Unsystematic Risk – Also known as “specific risk,” this risk is specific to individual stocks and can be diversified away as the investor increases the number of stocks in his or her portfolio.
In more technical terms, it represents the component of a stock’s return that is not correlated with general market moves.
Modern Portfolio Theory
M.P.T. shows that specific risk can be removed through diversification.
Diversification still doesn’t solve the problem of systematic risk
A portfolio of all the shares in the stock market can’t eliminate that risk.
C.A.P.M. evolved as a way to measure this systematic risk.
Market Premium
Market Premium (Rm-rf) = The return of the market in excess of the risk-free rate.
BETA Correlation
BETA of 1 = Moves exactly with the market
BETA of 1.5 = Stock moves 1.5 X the market
BETA of 0.5 = Stock moves 0.5 X the market
Market moves 10%
BETA of 1 = 10%
BETA of 1.5 = 15%
BETA of 0.5 = 5%.
Interpreting Beta
A beta of 1 indicates that the security’s price moves with the market.
A beta of less than 1 means that the security is theoretically less volatile than the market.
A beta of greater than 1 indicates that the security’s price is theoretically more volatile than the market.
