Capital Asset Pricing Model

1
Capital Asset Pricing Model

• Model that relates risk to rate of return.
• Tells investors how much they should require as a
  rate of return when buying a given stock, given
  the stocks sensitivity to market risk.
• (Remember, no reward for bearing company-specific
  risk. Investors should diversify!)

2
Kc Rf (Km - Rf)?

• Kc Common stockholders required rate of return
• Rf Risk-free rate of return
• Km Required rate of return on portfolio of all
  stocks required return on an average-risk stock
• ? Beta

3
Risk-free Rate of Return

• Rf has two components
• 1) A true, or real, rate of return that would be
  earned in a perfect world
• 2) An inflation premium (points to cover
  investors for rate of inflation)
• Rf can be estimated using return on T bills

4
Market Rate of Return

• Km is an estimate of what investing in the whole
  stock market would provide as a rate of return.
• Estimate Km by looking at predictions for market
  index like SP 500.
• Difficult to forecast easier to evaluate using
  past data.

5
(Km - Rf) Market Price of Risk

• Difference between return on whole market and
  risk-free rate of return.
• Extra reward (points) to investors for exposure
  to market risk.
• Size of market price of risk reflects investors
  degree of risk aversion (how investors feel about
  investing in the stock market).

6
(Km - Rf)? Risk Premium

• Market price of risk tailored for how sensitive a
  company is to market risk
• Average market risk (? 1.0) Required return
  Market return
• Above average market risk (? gt 1.0) Required
  return gt Market return
• Below average market risk (? lt 1.0) Required
  return lt Market return

7
Graphing CAPM

• X axis ? (Market Risk)
• Y axis Kc (Required Rate of Return)
• Relationship is linear - just need two points to
  graph CAPM
• 1) If ? 0, Kc Rf
• 2) If ? 1.0, Kc Km

8
Security Market Line (SML)

• Graphically shows relationship between market
  risk and required rate of return
• Slope of SML
• Rise/Run
• (Y1 - Y0)/(X1 - X0)
• Change in Kc/Change in ?
• Market price of risk (Km - Rf)

9
Slope of SML

• The slope of the SML reflects investors degree
  of Risk Aversion.
• When slope is steep (high market price of risk,
  high required rates of return), this indicates
  that investors are nervous (worried, concerned)
  about investing in the stock market and want
  higher returns on every stock.

10

• When slope of SML is flatter (lower market price
  of risk, lower required rates of return for every
  stock), this reflects that investors are more
  comfortable investing in the stock market and
  dont perceive market risk as being such a
  danger.
• Changes in slope reflect changes in investors
  perceptions about market risk.

11
SML and Changes in Inflation

• When inflation changes, the risk-free rate of
  return changes (inflation is one of its
  components).
• Y intercept changes.
• Slope remains constant (assuming investors
  perceptions about market risk are unchanged).

12
Changes in Inflation

• When Rf increases, Kc increases by the same
  amount.
• Higher inflation leads to higher required rates
  of return for all stocks.
• When Rf decreases, Kc decreases by the same
  amount.
• Lower inflation leads to lower required rates of
  return for all stocks.