CAPM part 2
- 1. GREETINGS TO ALL OF YOU!!! Group: 4 Mango Squad
- 2. Agenda Differential borrowing and lending Rates Zero-Beta Model Transaction Cost Heterogeneous Expectation and planning Periods Taxes Empirical tests of the CAPM Stability of Beta Relationship between systematic risk and return
- 3. DIFFERENTIAL BORROWING AND LENDING RATES One of the first assumptions of the CAPM was that investors could borrow and lend any amount of money at the risk free rate. It is reasonable to assume that investors can lend unlimited amount at the risk free rate by buying government securities (e.g. T-Bills). In contrast, it is quite unlikely that investor can borrow unlimited amount at the T-bill rate. For example, When T-bills are yielding 4 percent, most individuals would have to pay about 6 or 7 percent to borrow at a bank.
- 4. Zero-Beta Model A zero-beta portfolio is a portfolio constructed to have zero systematic risk or, in other words, a beta of zero. A zero-beta portfolio would have the same expected return as the risk-free rate. Such a portfolio would have zero correlation with market movements, given that its expected return equals the risk-free rate or a relatively low rate of return compared to higher-beta portfolios. Examples: The investments comprised in a zero-beta portfolio are chosen in such a way that the portfolio's value does not fluctuate as a result of market movements. In other words, a zero-beta portfolio eliminates systematic risk.
- 5. Transaction Cost The expenses associated with buying and selling securities, including commissions, purchase and redemption fees, exchange fees, and other miscellaneous costs are called portfolio transaction costs. In a mutual fund prospectus, these expenses are separately listed from the fund’s expense ratio.
- 7. Heterogeneous Expectation and planning Periods If all investors had different expectations about risk and return, each would have a unique CML or SML, and the composite graph would be a group of lines with a breadth determined by the divergence of expectations. If all investors had similar information and back ground, The width of the group would be reasonably narrow. Chiarella, Dieci, and He(2010) develop an extension of the CAPM where investors are grouped by similar beliefs.
- 8. TAXES • The expected returns in the CAPM are pretax returns. In fact, the actual returns for most investors are affected as follows:
- 9. Example- Mr. Jon Snow buys share of BATA company @tk100 per Share and sale it @tk110 at the end of the year. He got Dividend @tk5 per share of that year and tax rate is 10%. Solution:
- 10. Empirical tests of the CAPM Formula of CAPM E(Ri)= RFR+(Rm-RFR)𝛽 E(Ri)= Required Rate of Return, On assets(i)/cost of equity capital RFR= Expected rate of return on risk free rate assets Rm= Average return on market Portfolio 𝛽= Risk of the assets Suppose, RFR=10%, Rm=15%, 𝛽=1 Then, What is the value of E(Ri) ????
- 11. A beta coefficient is a measures of volatility or systematic risk of an individual stock in comparison to the unsystematic risk of the entire market. Stability of beta Generally Beta coefficient is 1.0. It is indicate that the stock price actively strongly correlated with the market. Generally we know that, the risk measures are not stable for individual stock. So beta is instability for the individual stock. But beta may be stable when the stock is portfolio. Further that, the large portfolio (over 50 stock) and the longer period. The estimation of beta may be stable. What is beta?
- 12. Relationship between systematic risk and return The ultimate question regarding the CAPM is whether it is useful in explaining the return on risky assets. Specifically, is there a positive linear relationship between the systematic risk and the rates of return on these risky assets? Sharpe &Cooper found a positive relationship between return and risk, although it was not completely linear. Because of the statistical problems with individual stocks. There are three effect on the relationship between systematic risk and return. 1.Effect of skewness on the relationship. 2.Effect of size, P/E and leverage. 3.Effect of Book-to- Market value: The Fama-French Study.
- 13. Effect of Book-to-Market value: The Fama-French Study (1992): Fama and French evaluated the joint roles of market beta, size, E/P, financial leverage, and the book-to-market equity ratio in the cross section of average returns on the NYSE, AMEX and NASDAQ stocks. While some earlier studies found a significant positive relationship between beta and average rate of return disappears during the period 1963 to 1990, even when beta is used alone to explain average returns. In contrast, univariate tests between average returns and size, leverage, E/P and book-to-market equity (BE/ME) indicate that all of these variables are significant and have the expected sign. Fama and French concluded that the size and book-to-market equity capture the cross-sectional variation in average stock returns associated with size, E/P, book-to-market equity, and leverage. Moreover, the two variables, BE/ME appears to subsume E/P and leverage. Following these results, Fama and French (1993) suggested the use of a three-factor CAPM model.
- 14. Are You Clear?
- 15. Thanks Everyone!!! Have a nice Day!!!