INTRODUCTION No matter how much we diversify our investments, its impossible to get rid of all the risk. As investors, we deserve a rate of return that compensates us for taking on risk. The capital asset pricing model (CAPM) helps us to calculate investment risk and what return on investment we should expect.
Birth of a Model•WILLIAM SHARPE, SET OUT IN HIS 1970 BOOK"PORTFOLIO THEORY AND CAPITAL MARKETS."
Types of RiskSystematic RiskUnsystematic Risk
“Formula” Kc = Rf + (Km – Rf)Kc = Common stock holders required rate of return.Rf = Risk free return.Km = Required rate of return on portfolio of all stocks, required return on average-risk stock. = Beta.
“Beta” is this measure--gauges the tendency of a security’s return to move in tandem with the overall market’s return. 1 Average systematic risk 1 High systematic risk, more volatile than the market 1 Low systematic risk, less volatile than the market
Betas for a Five-year Period (1987-1992)Company Name (1987-1992) BetaTucson Electric Power 0.65California Power & Lighting 0.70 2006 Betas:Litton Industries 0.75Tootsie Roll 0.85Quaker Oats 0.95Standard & Poor’s 500 Stock 1.00IndexProcter & Gamble 1.05General Motors 1.15Southwest Airlines 1.35Merrill Lynch 1.65Roberts Pharmaceutical 1.90
What CAPM Means for YouThis model presents a very simple theory thatdelivers a simple result. The theory says that theonly reason an investor should earn more, onaverage, by investing in one stock rather thananother is that one stock is riskier. Notsurprisingly, the model has come to dominatemodern financial theory.
Assumptions of CAPM All investors:Aim to maximize economic utilities.Are rational and risk-averse.Are broadly diversified across a range of investments.Are price takers, i.e., they cannot influence prices.Can lend and borrow unlimited amounts under the risk freerate of interest.Trade without transaction or taxation costs.Deal with securities that are all highly divisible into smallparcels.Assume all information is available at the same time to allinvestors.Further, the model assumes that standard deviation of pastreturns is a perfect proxy for the future risk associated witha given security.