Capital Asset Pricing Model ( Capm )

Capital asset pricing model or CAPM is a financial model that measures the risk premium inherent in equity investments like common stocks while Discounted Cash Flow or DCF compares the cost of an investment with the present value of future cash flows generated by the investment with the mindset being that if the cash flow is positive, then the investment is good. Generally speaking, CAPM is a model that describes the relationship between risk and expected return and DCF is a valuation method used to estimate the attractiveness of an investment opportunity. So what are the differences, advantages and disadvantages of each one? How

CAPM results can be compared to the best expected rate of return that investor can possibly earn in other investments with similar risks, which is the cost of capital. Under the CAPM, the market portfolio is a well-diversified, efficient portfolio representing the non-diversifiable risk in the economy. Therefore, investments have similar risk if they have the same sensitivity to market risk, as measured by their beta with the market portfolio.

“Higher risks lead to higher returns” is one of the basic concepts in the investment theory. Also, the CAPM, thought for decades at universities as one of the basic asset pricing models, supports it.

The expected return for each of the stocks has been calculated by the Capital Asset Pricing Model. The risk free rate is one of the variables used in the CAPM formula. The risk free rate has been assumed here at 7% based on historical statistics as no information has been given regarding it. The second variable is the return on market. This return has been estimated from the average monthly return by transforming it into effective expected annual rate of return. Finally, the third variable used in the CAPM formula is beta which has been calculated in the third question. This beta incorporates the systematic risk in the formula to calculate the expected return for a particular stock. The expected return for Brown Group is 14.87% and for California RIET it is 8.00%. This shows that the expected return for Brown Group is much higher than the expected return of California RIET.

a. Find the Expected Rate of Return on the Market Portfolio given that the Expected Rate of Return on Asset "i" is 12%, the Risk-Free Rate is 4%, and the Beta (b) for Asset "i" is 1.2.

CAPM is a highly acclaimed theory of risk and return for securities in a competitive capital market. The path breaking theory won Sharpe, Markowitz, and Miller the Nobel Memorial Prize in Economics in 1990. CAPM establishes the Beta coefficient as a measure of the systematic risk of an asset. The systematic risk is also known as market risk. This risk cannot be eliminated. This systematic risk is uncontrollable. The unsystematic risks include the risk that influences a single company or a small group of company and the same is controllable and can be mitigated through diversification.

This paper aims to analyze the validity of the CAPM model of predicting returns for stocks by empirically testing the model with past financial data. The CAPM model is defined as R_i=r_f+ β_i (R_m-r_f). R_i represents the return on stock i, and is what the CAPM model attempts to define or predict. r_f represents the risk free rate available at the time the model is being analyzed, a figure that’s important for understanding both minimum return figures and the return premium offered by the market. β_i represents the Beta of stock i and is a measure of a given company’s volatility relative to the market they are in. If β_i is one, then the company is at market risk, if it is lower than one then it is below market risk, and if it is higher than one then it is above market risk. The only stock that would have a Beta of 0 would be a risk free stock, or whatever security you are using for your risk free rate. β_i is calculated as (COVARIANCE(r_i-r_f,〖 r〗_m-r_f))/(VARIANCE(〖 r〗_m-r_f)).(R_m-r_f) represents the Market Risk Premium, or the level of return an average stock in the market would return in excess of the risk free rate.

Ever wonder if generating alpha is a zero-sum game or if quotes like the below hold:

Capital asset pricing has always been an active area in the finance literature. Capital Asset Pricing Model (CAPM) is one of the economic models used to determine the market price for risk and the appropriate measure of risk for a single asset. The CAPM shows that the equilibrium rates of return on all risky assets are function of their covariance with the market portfolio. This theory helps us understand why expected returns change through time. Furthermore, this model is developed in a hypothetical world with many assumptions.

Capital asset pricing model (CAPM) first provide the coherent framework for answering the relationship of expected return and the risk of investments and how equilibrium price come out.(Perold, A. F. ,2004) The initial goal of CAPM is to assess the risky assets such as stock. And the stock value is mostly according to the degree of risk that the held shares might get the return. These properties are similar to venture capital and both of them discounted future earnings in accordance with risk premium. So that, CAPM can used to determine the discount rate of the venture investment project at the same time.

The Capital Asset Pricing Model (CAPM), was first developed by William Sharpe (1964), and later extended and clarified by John Lintner (1965) and Fischer Black (1972). Four decades after the birth of this model, CAPM is still accepted as an appropriate technique for evaluating financial assets and retains an important place in both academic scholars and finance practitioners. It is used to estimate cost of capital for firms, evaluating the performance of managed portfolios and also to determine asset prices. Since the inception of this model there have been numerous researches and empirical testing to assess the strength and the validity of the model.

CAPM model builds on the model by Markowitz(1959).Markowitz assumes investors to be rational and risk averse. The model is one period model in which investor chooses portfolio at time t-1 in anticipation of stochastic return in period t. He uses mean variance criterion that states that investor will either choose highest expected return portfolio for given level of variance or lowest variance for a given level of expected returns

CAPM is simple period model that demonstrates the linear relationship between systematic risk of an asset and expected market return. The formula of CAPM is

In 1959, Markowitz laid a portfolio theory where he introduced mean-variance efficient portfolio that explained minimum variance for given expected return and maximum return for given variance. This revolutionized the finance field and provided groundwork for Capital Asset Pricing Model (CAPM) founded by William F. Sharpe (1964) and John Lintner (1965). Sharpe and Lintner showed that when investors hold mean-variance efficient portfolio and expect homogeneously, then even in absence of market fluctuations the portfolio formed would itself be mean-variance efficient portfolio.

In order to prove the validity of CAPM model in Indian Stock Market Fama and MacBeth’s traditional approach was used as the model to prove the hypothesis. The analysis period is taken from year starting 1st January, 1999 to 31st December 2013, a total time period of 15 years. This period was divided into seven 9-year sub-periods with eight overlapping period. The periods are been continuously overlapped to reduce the variability of the beta co-efficient that were estimated.