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Capital Asset Pricing Model

Capital Asset Pricing Model. presented by: Ryan Andrews and Amar Shah. Definition of CAPM. Capital Asset Pricing Model

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Capital Asset Pricing Model

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  1. Capital Asset Pricing Model presented by: Ryan Andrews and Amar Shah

  2. Definition of CAPM • Capital Asset Pricing Model • States that the expected return on a specific asset equals the risk-free rate plus a premium that depends on the asset’s beta and the expected risk premium on the market portfolio.

  3. Assessing Risk • Two types of risk in securities • Systematic Risk • Unsystematic Risk • Risk can be reduced but not eliminated • Diversification

  4. The Purpose of CAPM • CAPM works to evaluate risk • The equation says how much of return you should earn depending upon risk exposure

  5. CAPM Formula • E(Rp) = rf + βp(E(Rm) – rf) • E(Rp) : Expected return on capital asset • rf : Risk-free rate of return • βp : Sensitivity of the asset returns to market returns • E(Rm) : Expected return of the market

  6. Beta • The measure of a particular stock’s risk • Relative Volatility • Market behavior = Beta of 1 • Higher than 1: Capital asset is more volatile than the market • Lower than 1: Capital asset is less volatile than the market

  7. Security Market Line • Use to construct a portfolio of T-Bills and market portfolio to achieve the desired level of risk and return

  8. Sample Problem Walkthrough • Currently the risk-free rate equals 5% and the expected return on the market portfolio equals 11%. An investment analyst provides you with the following information: Stock Beta Expected Return A 1.33 12% B 0.7 10% C 1.5 14% • Indicate whether each stock is overpriced, under priced, or correctly priced.

  9. Stock A • E(Rp) = rf + βp(E(Rm) – rf) • 5% + 1.33(11% - 5%) = 12.98% • 12.98% > 12% so its underpriced

  10. Stock B • E(Rp) = rf + βp(E(Rm) – rf) • 5% + 0.7(11% - 5%) = 9.2% • 9.2% < 10% so its overpriced

  11. Stock C • E(Rp) = rf + βp(E(Rm) – rf) • 5% + 1.5(11% - 5%) = 14% • 14% = 14% so its correctly priced

  12. Sample Problem A particular stock sells for $30. The stock’s beta is 1.25, the risk free rate is 4%, and the expected return on the market portfolio is 10%. If you forecast that the stock will be worth $33 next year (assume no dividends), should you buy the stock or not and what is the expected price? A.) Yes, it will be worth $33.45 B.) Yes, it will be worth $35.00 C.) No, it will be worth $32.50 D.) No, it will be worth $30.00

  13. Solution • E(Rp) = rf + βp(E(Rm) – rf) • rf = 4% • βp = 1.25 • E(Rm) = 10% • E(Rp) = ? • Plug in numbers and solve for E(Rp) • E(Rp) = 4% + 1.25(10% - 4%) = 11.5%

  14. Solution Cont. • Use TVM functions on calculator to finish up the problem • PV = $30 • I/Y = 11.5% • N = 1 • PMT = 0 • CPT, FV = $33.45 • $33.45 > $33, so buy this stock

  15. Conclusion • CAPM predicts E(r) on a stock using the stock’s beta, the risk-free rate, and the market risk premium • Offers insight into the future, but not a guarantee • Very useful, offers yet another way of investing safely

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