The Capital Asset Pricing Model CAPM

1
The Capital Asset Pricing Model (CAPM)

• The CAPM has
• a macro component that explains risk and return
  in a portfolio context, and
• a micro component that explains individual stock
  returns.
• The micro component is also used to value stocks.

2
The Capital Market Line

• The capital market line
• adds a risk-free return, and
• redefines the efficient frontier.

3
The Capital Market Line
4
Risk and Return

• The investor continues to select the portfolio
  that
• offers the highest return for a given level of
  risk, and
• maximizes satisfaction.
• Different investors may select different
  combinations of risk and return.

5
Risk and Return

• Different asset classes lie on the capital market
  line

6
Beta Coefficients

• An index of risk
• Measures the volatility of a stock (or portfolio)
  relative to the market

7
Beta Coefficients Combine

• The variability of the assets return
• The variability of the market return
• The correlation between
• the stock's return, and
• the market return.

8
Beta Coefficients

• Beta coefficients are the slope of the regression
  line relating
• the return on the market (the independent
  variable) to
• the return on the stock (the dependent variable)

9
Beta Coefficients
10
Interpretation of the Numerical Value of Beta

• Beta 1.0 Stock's return has same volatility as
  the market return.
• Beta gt 1.0 Stock's return is more volatile than
  the market return.

11
Interpretation of the Numerical Value of Beta
12
Interpretation of the Numerical Value of Beta

• Beta lt 1.0 Stock's return is less volatile than
  the market return.

13
Interpretation of the Numerical Value of Beta
14
High Beta Stocks

• More systematic market risk
• May be appropriate for high-risk tolerant
  (aggressive) investors.

15
Low Beta Stocks

• Less systematic market risk
• May be appropriate for low-risk tolerant
  (defensive) investors.

16
Individual Stock Betas

• May change over time
• Tendency to move toward 1.0, the market beta

17
Portfolio Betas

• Weighted average of the individual asset's betas
• May be more stable than individual stock betas

18
Beta Coefficients and The Security Market Line

• The return on a stock depends on
• the risk free rate (rf)
• the return on the market (rm)
• the stock's beta
• the return on a stockk rf (rm - rf)beta

19
Beta Coefficients and The Security Market Line

• The figure relating systematic risk (beta) and
  the return on a stock

20
Beta Coefficients and The Security Market Line
21
Arbitrage Pricing Theory (APT)

• In the CAPM
• A stock's return depends only on
• the market return, and
• the volatility of the stock (the beta).
• APT is an alternative to the Capital Asset
  Pricing Model.

22
Arbitrage

• Buying in one market and simultaneously selling
  in another market to take advantage of price
  differentials
• Assures there can be only one price
• Assures that portfolios with the same risk will
  have the same returns

23
APT explains security returns in terms of

• The expected return
• A series of factors that may affect security
  prices
• How the individual stock responds to
  unanticipated changes in those factors

24
Common Factors

• Unexpected inflation
• Unexpected changes in industrial production
• Unanticipated shifts in risk premiums
• Unanticipated changes in the structure of yields