Financial Mgt. - Capital Asset Pricing Model

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Financial Mgt. - Capital Asset Pricing Model

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  • 1.Presented by: Arpit Agarwal Heena Banka Pooja Chandak

2. overview About CAPM Assumptions of CAPM Market Efficiency Advantages of CAPM Disadvantages of CAPM Conclusion 3. ABOUT CAPM It represents the linear relationship between the return required on an investment and its systematic risk It is represented by the formula: Ke = Rf + (Rm Rf) Ke = Risk free rate + Risk premium 4. BETA (SYSTEMATIC RISK) = cov. (K e , R m ) M 2 Value of Characteristics of security < 1 Less sensitive to market = 1 Equally sensitive to market > 1 More sensitive to market 5. SML Rf RateofReturnoftheSecurity SML X 6. SML Rf RateofReturnoftheSecurity SML Y 7. ASSUMPTIONS OF CAPM Investors hold diversified portfolios Single-period transaction horizon Investors can borrow and lend at the risk-free rate of return Perfect capital market 8. MARKET EFFICIENCY Market efficiency has varying degrees: Weak efficiency Semi-strong Strong 9. WEAK EFFICIENCY No investor can earn excess returns by developing trading rules based solely on historical price or return information 10. SEMI-STRONG EFFICIENCY No investor can earn excess returns from using trading rules based on any publicly available information 11. STRONG EFFICIENCY No investor can earn excess returns using any information whether publicly available or not 12. ADVANTAGES OF CAPM It considers only systematic risk, reflecting a reality in which most investors have diversified portfolios from which unsystematic risk has been essentially eliminated It generates a theoretically-derived relationship between required return and systematic risk which has been subject to frequent empirical research and testing It is generally seen as a much better method of calculating the cost of equity than the dividend growth model (DGM) in that it explicitly takes into account a companys level of systematic risk relative to the stock market as a whole 13. Disadvantages The model assumes that asset returns are (jointly) normally distributed random variables The model assumes that the variance of returns is an adequate measurement of risk The model does not appear to adequately explain the variation in stock returns The model assumes that given a certain expected return investors will prefer lower risk (lower variance) to higher risk and conversely given a certain level of risk will prefer higher returns to lower ones 14. Contd The model assumes that all investors have access to the same information and agree about the risk and expected return of all assets The market portfolio should in theory include all types of assets that are held by anyone as an investment (including works of art, real estate, human capital...) 15. conclusion Research has shown the CAPM to stand up well to criticism, although attacks against it have been increasing in recent years. Many other models have been developed which are used extensively these days like Fench and Fama Model. However, the CAPM remains a very useful item in the financial management toolkit. 16. THANK YOU!!!!!!