It shows the relationship between expected return and systematic risk of individual asset or securities or portfolios

1. BY:
ARVINDER PAL KAUR
FACULTY OF MANAGEMENT
NWGOI, DHUDIKE MOGA

2. CAPM
 CAPM refers to Capital Asset Pricing Model.
 CAPM was introduced by William F Sharpe.
 CAPM is a framework for determining the Equilibrium
expected return for risky assets.
 It shows the relationship between expected return and
systematic risk of individual asset or securities or
portfolios.
 It emphasize that risk factor in portfolio theory is a
combination of two risks- Systematic risk and
unsystematic risk.

3. ASSUMPTIONS
 CAPM model relies on following Assumptions that 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 risk free rate of
interest.
 Have homogenous expectations.
 No transaction cost.

4. Concept
 The CAPM is a model for pricing an individual security
or portfolio.
 For individual securities, we make use of Security
Market Line (SML) and its relation to expected return
and systematic risk (beta) to show how the market
must price individual securities in relation to their
security risk class.
 The SML enables us to calculate the reward-to-risk
ratio for any security in relation to that of the overall
market.

5. Formula
 CAPM :
E(Ri) = Rf + Bi {E(Rm) – Rf}
Where:
 E(Ri) is expected return on the capital asset
 Rf is the risk free rate of interest.
 Bi (the Beta)
 E(Rm) is the expected return of the market.
 E(Rm) – Rf is sometimes known as the market premium
(the difference between the expected market rate of
return and the risk free rate of return)

6. Asset Pricing
 Once the expected/required rate of return E(Ri) is
calculated using CAPM, we can compare this required
rate of return to the asset’s estimated rate of return
over a specific investment horizon to determine
whether it would be an appropriate investment or not.

7. Problems of CAPM
 This model is based on vague and inappropriate
assumptions.
 The model wrongly assumes that all active and
potential shareholders have access to the same
information and agree about the risk and expected
return of all assets (homogeneous expectations
assumption)
 The model does not appear to adequately explain the
variation in stock returns.