8/13/2019 Lect 11 - FM&I - CAPM etc

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Milind S Limaye

8/13/2019 Lect 11 - FM&I - CAPM etc

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The capital asset pricing model

Whenever an investment is made, for example in theshares of a company listed on a stock market, there is a

risk that the actual return on the investment will bedifferent from the expected return. Investors take therisk of an investment into account when deciding on thereturn they wish to receive for making the investment.

The CAPM is a method of calculating the return requiredon an investment, based on an assessment of its risk

Milind S Limaye

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SYSTEM TIC ND UNSYSTEM TIC RISK

If an investor has a portfolio of investments in theshares of a number of different companies, it might be

thought that the risk of the portfolio would be theaverage of the risks of the individual investments.

In fact, it has been found that the risk of the portfoliois less than the average of the risks of the individual

investments. By diversifying investments in a portfolio,therefore, an investor can reduce the overall level of riskfaced.

Milind S Limaye

8/13/2019 Lect 11 - FM&I - CAPM etc

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There is a limit to this risk reduction effect, however, so

that even a fullydiversifiedportfolio will not eliminaterisk entirely. The risk which cannot be eliminated byportfolio diversification is called undiversifiableriskorsystematic risk, since it is the risk that is associatedwith the financial system.

The risk which can be eliminated by portfoliodiversification is called diversifiablerisk,unsystematicrisk, or specific risk, since it is the risk that is

associated with individual companies and the sharesthey have issued.

The sum of systematic risk and unsystematic risk iscalled total risk.

Milind S Limaye

8/13/2019 Lect 11 - FM&I - CAPM etc

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The CAPM assumes that investors hold fully diversifiedportfolios. This means that investors are assumed bythe CAPM to want a return on an investment based onits systematic risk alone, rather than on its total risk.The measure of risk used in the CAPM, which is called

beta,is therefore a measure of systematic risk.

The minimum level of return required by investorsoccurs when the actual return is the same as theexpected return, so that there is no risk at all of the

return on the investment being different from theexpected return. This minimum level of return is calledthe risk-free rate of return.

Milind S Limaye

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The formula for the CAPM, is as follows:

E(ri) = Rf + i(E(rm) - Rf)

E(ri) = return required on financial asset i

Rf = risk-free rate of return

i = beta value for financial asset i

E(rm) = average return on the capital market

Milind S Limaye