The document outlines key concepts related to the Capital Asset Pricing Model (CAPM), including differential borrowing and lending rates, the zero-beta model, transaction costs, and empirical tests. It discusses how investor expectations vary, the implications of taxes on returns, and examines the stability of beta as a measure of systematic risk. Additionally, it highlights findings from the Fama-French study, suggesting that size and book-to-market equity significantly influence average stock returns, leading to the proposal of a three-factor CAPM model.

1. GREETINGS TO ALL OF YOU!!!
Group: 4
Mango Squad

2. Agenda
 Differential borrowing and lending Rates
 Zero-Beta Model
 Transaction Cost
 Heterogeneous Expectation and planning Periods
 Taxes
 Empirical tests of the CAPM
 Stability of Beta
 Relationship between systematic risk and return

3. DIFFERENTIAL BORROWING AND LENDING
RATES
One of the first assumptions of the CAPM was that investors could borrow and lend
any amount of money at the risk free rate. It is reasonable to assume that investors
can lend unlimited amount at the risk free rate by buying government securities (e.g.
T-Bills). In contrast, it is quite unlikely that investor can borrow unlimited amount
at the T-bill rate.
For example, When T-bills are yielding 4 percent, most individuals would have to
pay about 6 or 7 percent to borrow at a bank.

4. Zero-Beta Model
A zero-beta portfolio is a portfolio constructed to have zero systematic risk or, in
other words, a beta of zero. A zero-beta portfolio would have the same expected
return as the risk-free rate. Such a portfolio would have zero correlation with
market movements, given that its expected return equals the risk-free rate or a
relatively low rate of return compared to higher-beta portfolios.
Examples:
The investments comprised in a zero-beta portfolio are chosen in such a way that
the portfolio's value does not fluctuate as a result of market movements. In other
words, a zero-beta portfolio eliminates systematic risk.

5. Transaction Cost
The expenses associated with buying and selling securities, including
commissions, purchase and redemption fees, exchange fees, and other
miscellaneous costs are called portfolio transaction costs. In a mutual fund
prospectus, these expenses are separately listed from the fund’s expense
ratio.

7. Heterogeneous Expectation and planning Periods
If all investors had different expectations about risk and return, each
would have a unique CML or SML, and the composite graph would be a
group of lines with a breadth determined by the divergence of
expectations. If all investors had similar information and back ground,
The width of the group would be reasonably narrow. Chiarella, Dieci,
and He(2010) develop an extension of the CAPM where investors are
grouped by similar beliefs.

8. TAXES
• The expected returns in the CAPM are pretax returns. In fact, the actual returns
for most investors are affected as follows:

9. Example- Mr. Jon Snow buys share of BATA company @tk100 per
Share and sale it @tk110 at the end of the year. He got Dividend @tk5
per share of that year and tax rate is 10%.
Solution:

10. Empirical tests of the CAPM
Formula of CAPM
E(Ri)= RFR+(Rm-RFR)𝛽 E(Ri)= Required Rate of Return, On assets(i)/cost of
equity capital
RFR= Expected rate of return on risk free rate assets
Rm= Average return on market Portfolio
𝛽= Risk of the assets
Suppose, RFR=10%, Rm=15%, 𝛽=1 Then, What is the value of E(Ri)
????

11. A beta coefficient is a measures of volatility or systematic risk of an individual
stock in comparison to the unsystematic risk of the entire market.
Stability of beta
Generally Beta coefficient is 1.0. It is indicate that the stock price actively strongly
correlated with the market. Generally we know that, the risk measures are not stable
for individual stock. So beta is instability for the individual stock. But beta may be
stable when the stock is portfolio. Further that, the large portfolio (over 50 stock)
and the longer period. The estimation of beta may be stable.
What is beta?

12. Relationship between systematic risk and return
The ultimate question regarding the CAPM is whether it is useful in explaining the
return on risky assets. Specifically, is there a positive linear relationship between the
systematic risk and the rates of return on these risky assets? Sharpe &Cooper found
a positive relationship between return and risk, although it was not completely
linear. Because of the statistical problems with individual stocks. There are three
effect on the relationship between systematic risk and return.
1.Effect of skewness on the relationship.
2.Effect of size, P/E and leverage.
3.Effect of Book-to- Market value: The Fama-French Study.

13. Effect of Book-to-Market value: The Fama-French Study (1992):
Fama and French evaluated the joint roles of market beta, size, E/P, financial leverage, and the
book-to-market equity ratio in the cross section of average returns on the NYSE, AMEX and
NASDAQ stocks. While some earlier studies found a significant positive relationship between
beta and average rate of return disappears during the period 1963 to 1990, even when beta is used
alone to explain average returns. In contrast, univariate tests between average returns and size,
leverage, E/P and book-to-market equity (BE/ME) indicate that all of these variables are
significant and have the expected sign.
Fama and French concluded that the size and book-to-market equity capture the cross-sectional
variation in average stock returns associated with size, E/P, book-to-market equity, and leverage.
Moreover, the two variables, BE/ME appears to subsume E/P and leverage. Following these
results, Fama and French (1993) suggested the use of a three-factor CAPM model.

14. Are You
Clear?

15. Thanks Everyone!!!
Have a nice Day!!!