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CAPM_Presentation

CAPM_Capital Asset Pricing Model

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CAPM_Presentation

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  1. CAPM-Capital Asset Management Course: Risk and Return Presented by Mohammad Mohin Uddin Researcher, Learner, Trainer, Chemical Engineer

  2. Introduction • A model that describes the relationship between risk and expected return and that used in the pricing of risky securities. • The model was introduced by jack Treynor, William Sharpe, John Linter and Jan Mossin independently, building on the earlier work of Harry Markowitz  on diversification an modern portfolio theory. • The general idea behind CAPM is that investors need to be compenetrated  in two ways- • Time value of Money  • Risk.

  3. CAPM Assumptions • Investors make their investment decisions on the basis of risk-return assessments measured in terms of expected returns and standard deviation of returns. • The purchase or sale of a security is infinitely divisible units. • Purchases and sales by a single investor cannot affect prices. This means that there is perfect competition where investors in total determine prices by their actions. • There are no transaction costs. Transactions costs are small, they are probably of minor importance in investment decision-making, and hence the are ignored. • There are no personal income taxes. Alternatively, the tax rates on dividends income and capital gains are same, thereby making the investor indifferent to the form in which the return o he investment is received (dividends and capital gains)

  4. CAPM Assumptions cont. • The investor can lend or borrow any amount of funds desired at a rate of interest equal to the rate for riskless securities. • The investors can sell short any amount of any shares. • Investors share homogeneity of expectations. The implies that investors have identical expectations about the decision period and decision inputs

  5. CAPM Mathematical equation Here.   R = Expected Return on security.  RF = Risk free rate.  B = beta of the security  Difference between expected return on market and risk-free rate = Risk premium.

  6. Efficient frontier with Riskless Lending and Borrowing • The efficient frontier, also known as the portfolio frontier, is a set of ideal or optimal portfolios expected to give the highest return for a minimal return. It manifests the risk-and return trade-off of a portfolio. • For building the frontier, there are three important factors to be taken into consideration: • Expected return, • Risk measured by Variance/ Standard Deviation. • Correlation between the returns of different assets.

  7. Efficient frontier with Riskless Lending and Borrowing The concave curve ABC represents an efficient frontier of risky portfolios Fig: Efficient frontier with introduction of lending

  8. The Capital Market Line (CML) • The capital market line (CML) represents portfolios that optimally combine risk and return. • CML is a special case of the capital allocation line (CAL) where the risk portfolio is the market portfolio. Thus, the slope of the CML is the Sharpe ratio of the market portfolio. • The intercept point of CML and efficient frontier would result in the most efficient portfolio called the tangency portfolio. Rp​ = Portfolio return rf​ = Risk free rate RT ​ = Market return σT​= Standard deviation of market returns σp​=standard deviation of portfolio returns​

  9. The Security Market Line (SML) • The security market line (SML) is a graphical representation of the capital asset pricing model (CAPM), which shows different levels of systematic, or market risk, of various marketable securities, plotted against the expected return of the entire market at any given time. • It is also known as the "characteristic line," the SML is a visualization of the CAPM, The market risk premium of a given security is determined by where it is plotted on the chart relative to the SML.

  10. The Security Market Line (SML) cont. • The formula can be illustrated by assuming few special cases: • Assume that: β = 0, Here, the expected return on the security is equal to the risk-free rate. Because a security with zero beta has no relevant risk, its expected return should equal the risk-free rate. • Assume that: β = 1, Here,  that is expected return on the security is equal to the expected return on the security is equal to the expected return on the market. Because the eta of the market portfolio is also  1.

  11. CML vs SML • Both postulate a linear (straight  line) relationship between risk and return. • In CML, the risk is defined as Total risk and is measured  by standard deviation. And SML  the risk is defined as systematic risk and is measured by beta. • CML is valid  only for efficient portfolios while, SML is valid for all portfolios and individual portfolios as well. • CML is the basis of the capital market theory while, SML is the basis of the capital asset pricing model.

  12. Thanks.

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