Module - Home

The Capital Asset Pricing Model

Modular Learning Outcomes

Upon successful completion of this module, the student will be able to satisfy the following outcomes:

•Case ?Distinguish between diversifiable and undiversifiable risks and explain the implications.

?Discuss the content and assumptions of the Capital Asset Pricing Model.
?Identify and explain practical uses for Capital Asset Pricing Model.
?Describe the process of risk/return analysis.

•SLP ?Describe the process of risk/return analysis.

?Describe the theoretical and practical problems associated with using the Capital Asset Pricing Model.
?Discuss the content and assumptions of the Capital Asset Pricing Model.
?Identify and explain practical uses for Capital Asset Pricing Model.

•Discussion ?Discuss the content and assumptions of the Capital Asset Pricing Model.

?Identify and explain practical uses for Capital Asset Pricing Model.
?Describe the process of risk/return analysis
?Describe the theoretical and practical problems associated with using the Capital Asset Pricing Model.

Module Overview

In Module 2 you learned about the importance of present value and the discount rate. But now that you know how to compute present value and you know what a discount rate is, how do you calculate an appropriate discount rate? That is one of the purposes of this module.

The Capital Asset Pricing Model (CAPM) is one of the most commonly used tools by financial professionals. Developed by Nobel Prize winning economist William Sharpe the CAPM is used today for a large number of purposes.

The CAPM is used to value stocks, and help choose portfolios. It is also used to estimate appropriate discount rates in present value calculations, especially in capital budgeting decisions. It is a major tools used in the assessment of the rate of return that shareholders of companies require as the 'minimum rate of return' that their company should earn on the investors' investment in the shares of the company.

Module - Background

The Capital Asset Pricing Model

Required Reading

I personally recommend reading up on the basic concepts behind the Capital Asset Pricing Model first before worrying about the formula. But still many of you are eager to learn the formulas first, so here are a few links below. But don't fixate on the formulas, spend an equal if not greater amount of time reading up on the basic concepts:

Investopedia (n.d.). Capital Asset Pricing Model, retrieved from: http://www.investopedia.com/terms/c/capm.asp

MoneyChimp, (n.d.) CAPM calculator, retrieved from: http://www.moneychimp.com/articles/valuation/capm.htm

QFinance, (n.d.) Capital Asset Pricing Model, retrieved from: http://www.financepractitioner.com/asset-management-calculations/capital-asset-pricing-model

Value Based Management, (n.d.) Capital Asset Pricing Model, retrieved from: http://www.valuebasedmanagement.net/methods_capm.html

To gain a deeper understanding of the CAPM and associated concepts beyond just the formula, read:

Damodaran, A. (n.d). Picking the right projects: Investment analysis. Retrieved from:
http://pages.stern.nyu.edu/~adamodar/pdfiles/cfovhds/inv.pdf

Risk and Return (1991). The Economist, 318, 72-73

This Article on Investment Analysis is a highly comprehensive overview on measuring risk and the use of the CAPM. This article is a good place to start because it will give you an idea of how the CAPM is used in the "real world" as well as demonstrate the basic concepts of this Module.

Financial Markets (2015) Pearson Learning Solution, New York

Managing Risk and Return (2015) Pearson Learning Solution, New York

Optional Reading

Financial Concepts: Capital Asset Pricing Model. (n.d.). Retrieved from http://www.investopedia.com/university/concepts/concepts8.asp

Teachmefinance.com. CAPM - The Capital Asset Pricing Model. Retrieved from http://www.teachmefinance.com/capm.html

Teachmefinance.com. The Security Market Line. Retrieved from http://teachmefinance.com/securitymarketline.html

Hamm, D. B. (2006). Managerial Finance: Chapter 13 - Return, Risk & the Security Market Line, OVU - Advance. Retrieved from http://web.ovc.edu/advance/hamm/fin13.ppt#1

Investopedia.com. The Capital Asset Pricing Model: An Overview. Retrieved from http://www.investopedia.com/articles/06/capm.asp

Investopedia.com. Financial Concepts: Capital Asset Pricing Model (CAPM). Retrieved from http://www.investopedia.com/university/concepts/concepts8.asp

Business.com. Capital Asset Pricing Model (CAPM). Retrieved from http://www.business.com/finance/capital-asset-pricing-model/

Module - Case

The Capital Asset Pricing Model

Assignment Overview

1. For each of the scenarios below, explain whether or not it represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning.

a. There's a substantial unexpected increase in inflation.
b. There's a major recession in the U.S.
c. A major lawsuit is filed against one large publicly traded corporation.

2. Use the CAPM to answer the following questions:

a. Find the Expected Rate of Return on the Market Portfolio given that the Expected Rate of Return on Asset "i" is 12%, the Risk-Free Rate is 4%, and the Beta (b) for Asset "i" is 1.2.

b. Find the Risk-Free Rate given that the Expected Rate of Return on Asset "j" is 9%, the Expected Return on the Market Portfolio is 10%, and the Beta (b) for Asset "j" is 0.8.

c. What do you think the Beta (β) of your portfolio would be if you owned half of all the stocks traded on the major exchanges? Explain.

3. In one page explain what you think is the main 'message' of the Capital Asset Pricing Model to corporations and what is the main message of the CAPM to investors?

Assignment Expectations

The Case report should be a two-page report. Please show your work for quantitative questions.

Module - SLP

The Capital Asset Pricing Model

Using Yahoo! Finance find the value of beta for your reference company. Write a two page paper discussing the following items:

a. What is the estimated beta coefficient of your company? What does this beta mean in terms of your choice to include this company in your overall portfolio?

b. Given the beta of your company, the present yield to maturity on U.S. government bonds maturing in one year (currently about 4.5% annually) and an assessment that the market risk premium (that is - the difference between the expected rate of return on the 'market portfolio' and the risk-free rate of interest) is 6.5%, use the CAPM equation in order to find out what is the present 'cost of equity' of your company? Explain what is the meaning of the 'cost of equity'.

c. Choose two other companies, look up their "Beta" and report the names of these companies and their betas. Suppose you invest one third of your money in each of the stocks of these companies. What will the beta of the portfolio be? Given the data in (b), what will the Expected Rate of Return on this portfolio be? Do you feel that the three-stock portfolio is sufficiently diversified or does it still have risk that can be diversified away? Explain.

SLP Assignment Expectations

In a two-page report explain your answers thoroughly with references to the background materials. Make sure to demonstrate a strong understanding of the concept of beta and the risk/return trade off.

Now that you have read about the CAPM, would you ever use it to make personal investment decisions? How can an individual investor use or think about CAPM?

Consider the following:

What is the main message of the CAPM? It evolves from the notion that investors in general aren't stupid: They diversify their investment funds into a well-diversified portfolio. More specifically-the main message of the CAPM is that the rate of return one should expect to earn on a particular investment is only related to the systematic risk of the security, not to its total risk. When you purchase a stock (because you like it or because you got a ‘tip'), you'll be exposed to the total risk of this stock, but the market theory implies that you'll only be compensated for a small proportion of that risk. Hence, if you do like risk you should invest in a well-diversified risky portfolio with many securities having a high beta, rather in an individual stock. Now go back to the initial question and present your thoughts...

Do research on the Internet and show the reference for the information. Don't forget to respond to a colleague's posting also.

Professor's Note: In addition to searching the Internet for text related to this threaded discussion, please watch the following video (click on the following link to access this video and further Part 2) and post your comments.

http://www.youtube.com/watch?v=LWsEJYPSw0k CAPM Capital Asset Pricing Model in 4 Easy Steps - What is Capital Asset Pricing Model Explained