1 / 15

Capital Asset Pricing Model

Capital Asset Pricing Model. presented by: Ryan Andrews and Amar Shah. Definition of CAPM. Capital Asset Pricing Model

karren
Download Presentation

Capital Asset Pricing Model

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Capital Asset Pricing Model presented by: Ryan Andrews and Amar Shah

  2. Definition of CAPM • Capital Asset Pricing Model • States that the expected return on a specific asset equals the risk-free rate plus a premium that depends on the asset’s beta and the expected risk premium on the market portfolio.

  3. Assessing Risk • Two types of risk in securities • Systematic Risk • Unsystematic Risk • Risk can be reduced but not eliminated • Diversification

  4. The Purpose of CAPM • CAPM works to evaluate risk • The equation says how much of return you should earn depending upon risk exposure

  5. CAPM Formula • E(Rp) = rf + βp(E(Rm) – rf) • E(Rp) : Expected return on capital asset • rf : Risk-free rate of return • βp : Sensitivity of the asset returns to market returns • E(Rm) : Expected return of the market

  6. Beta • The measure of a particular stock’s risk • Relative Volatility • Market behavior = Beta of 1 • Higher than 1: Capital asset is more volatile than the market • Lower than 1: Capital asset is less volatile than the market

  7. Security Market Line • Use to construct a portfolio of T-Bills and market portfolio to achieve the desired level of risk and return

  8. Sample Problem Walkthrough • Currently the risk-free rate equals 5% and the expected return on the market portfolio equals 11%. An investment analyst provides you with the following information: Stock Beta Expected Return A 1.33 12% B 0.7 10% C 1.5 14% • Indicate whether each stock is overpriced, under priced, or correctly priced.

  9. Stock A • E(Rp) = rf + βp(E(Rm) – rf) • 5% + 1.33(11% - 5%) = 12.98% • 12.98% > 12% so its underpriced

  10. Stock B • E(Rp) = rf + βp(E(Rm) – rf) • 5% + 0.7(11% - 5%) = 9.2% • 9.2% < 10% so its overpriced

  11. Stock C • E(Rp) = rf + βp(E(Rm) – rf) • 5% + 1.5(11% - 5%) = 14% • 14% = 14% so its correctly priced

  12. Sample Problem A particular stock sells for $30. The stock’s beta is 1.25, the risk free rate is 4%, and the expected return on the market portfolio is 10%. If you forecast that the stock will be worth $33 next year (assume no dividends), should you buy the stock or not and what is the expected price? A.) Yes, it will be worth $33.45 B.) Yes, it will be worth $35.00 C.) No, it will be worth $32.50 D.) No, it will be worth $30.00

  13. Solution • E(Rp) = rf + βp(E(Rm) – rf) • rf = 4% • βp = 1.25 • E(Rm) = 10% • E(Rp) = ? • Plug in numbers and solve for E(Rp) • E(Rp) = 4% + 1.25(10% - 4%) = 11.5%

  14. Solution Cont. • Use TVM functions on calculator to finish up the problem • PV = $30 • I/Y = 11.5% • N = 1 • PMT = 0 • CPT, FV = $33.45 • $33.45 > $33, so buy this stock

  15. Conclusion • CAPM predicts E(r) on a stock using the stock’s beta, the risk-free rate, and the market risk premium • Offers insight into the future, but not a guarantee • Very useful, offers yet another way of investing safely

More Related