CAPITAL ASSET PRICING MODEL

INTRODUCTIONNo matter how much we diversify our investments, it's impossible to get rid of all the risk. As investors, we deserve a rate of return that compensates us for taking on risk. The capital asset pricing model (CAPM) helps us to calculate investment risk and what return on investment we should expect.

•WILLIAM SHARPE, SET OUT IN HIS 1970 BOOK "PORTFOLIO THEORY AND CAPITAL MARKETS."

Birth of a Model

Types of RiskSystematic RiskUnsystematic Risk

“Formula”

“Formula”Kc = Rf + (Km – Rf)

Kc = Common stock holders required rate of return. Rf = Risk free return.

Km = Required rate of return on portfolio of all stocks, required return on average-risk stock.

= Beta.

“Beta” is this measure--gauges the tendency of a security’s

return to move in tandem with the overall market’s return.

1 Average systematic risk

1 High systematic risk, more volatile than the market

1 Low systematic risk, less volatile than the market

Betas for a Five-year Period(1987-1992)

Company Name (1987-1992) Beta

Tucson Electric Power 0.65

California Power & Lighting 0.70

Litton Industries 0.75

Tootsie Roll 0.85

Quaker Oats 0.95

Standard & Poor’s 500 Stock Index

1.00

Procter & Gamble 1.05

General Motors 1.15

Southwest Airlines 1.35

Merrill Lynch 1.65

Roberts Pharmaceutical 1.90

2006 Betas:

What CAPM Means for YouThis model presents a very simple theory that delivers a simple result. The theory says that the only reason an investor should earn more, on average, by investing in one stock rather than another is that one stock is riskier. Not surprisingly, the model has come to dominate modern financial theory.

Assumptions of CAPMAll investors:

Aim to maximize economic utilities.Are rational and risk-averse.Are broadly diversified across a range of investments.Are price takers, i.e., they cannot influence prices.Can lend and borrow unlimited amounts under the risk free rate of interest.Trade without transaction or taxation costs.Deal with securities that are all highly divisible into small parcels.Assume all information is available at the same time to all investors.

Further, the model assumes that standard deviation of past returns is a perfect proxy for the future risk associated with a given security.

But does it really work?

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