SAPM lecture 4 Capital Asset Pricing Model theory
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The Capital Asset Pricing Model (CAPM) describes how investors should price assets based on their risk levels. It assumes investors only consider risk and return, have homogeneous expectations, and can borrow and lend at the risk-free rate. The Capital Market Line plots expected returns against risk and identifies efficient investments. The Security Market Line is the graphical representation of CAPM, showing the expected return of individual assets based on their beta in relation to the market. Assets priced correctly will lie on the SML, while under- or over-valued assets will lie above or below it.
SAPM lecture 4 Capital Asset Pricing Model theory
- 1. Capital Asset Pricing Model (CAPM) Developed and modified by W.Sharpe and J. Tobin ingleyogeshh@gmail.com
- 2. • It is set of principles describing how people behave in the market. • It describes how Investor’s behavior should affect security prices rather than explaining what investors actually observe in the market. ingleyogeshh@gmail.com
- 3. Assumptions: • The investors objective is to maximize the utility of wealth • Investors make choices solely on the basis of risk and return • Investors have homogeneous expectations • Investors have identical one period time horizons • Information is freely available • There is risk free asset and investor can borrow and lend any amount of money at the risk free rate • There are no taxes, transaction costs, or other market imperfections • Total asset quantity is fixed and all assets are marketable and divisible • Capital markets are in equilibrium ingleyogeshh@gmail.com
- 4. Capital Market Line (CML) • Next step in deriving the asset pricing model is to define a set of criteria for identifying preferred investments • It utilizes only the mean and variance expected return to identify the investment that dominate • Using the mean as the measure of expected return and the standard deviation as the measure of risk, we can represent any investment in risk-return space as a single point • Introduction of risk free asset with borrowing and lending at the risk free rate leads to the CML • CML is a linear relationship between expected return and total risk • The difference between the CML and the old efficient frontier of assets identifies the risk ingleyogeshh@gmail.com
- 5. • The capital asset pricing model gives a relationship between a securities risk and return • The excess of return earned on any other security is the risk premium or the reward for the excess risk pertaining to that security • The market risk premium is the difference between Average Rate of Return on Market and Risk free rate. ingleyogeshh@gmail.com
- 6. Security Market Line (SML) • The graphical version of CAPM is called SML • It shows relationship between beta and required rate of return • CAPM identifies security return net of the risk free rate as proportional to the expected net market return, where beta serves as the constant proportionality • As a consequence of this relationship, all securities in equilibrium plot along straight line is called SML. • It is an alternative to CML which will use beta as the independent variable and will accommodate both portfolios and individual assets ingleyogeshh@gmail.com
- 7. • SML has positive slope, indicating that the expected return increases with risk • Expected return= Riskless rate + systematic risk premium which is proportional to its beta • If individual asset and portfolios are priced correctly, then all currently priced assets must lie on the SML ingleyogeshh@gmail.com
- 8. • An asset lying above SML is undervalued because it offers a return higher than what is consistent with the systematic risk it carries. • An asset lying below SML is overvalued because it offers a return lower than what is consistent with the systematic risk it carries ingleyogeshh@gmail.com