INTRODUCTION

An important task of the corporate financial manager is measurement of the companys cost of equity capital. But estimating the cost of equity causes a lot of head scratching; often the result is subjective and therefore open to question as a reliable benchmark. This report describes a method for arriving at that figure, a method spawned in the rarefied atmosphere of financial theory. The capital asset pricing model (CAPM) is an idealized portrayal of how financial markets price securities and thereby determine expected returns on capital investments. The model provides a methodology for quantifying risk and translating that risk into estimates of expected return on equity. A principal advantage of CAPM is the objective nature of the estimated costs of equity that the model can yield. CAPM cannot be used in isolation because it necessarily simplifies the world of financial markets. But financial managers can use it to supplement other techniques and their own judgment in their attempts to develop realistic and useful cost of equity calculations. Although its application continues to spark vigorous debate, modern financial theory is now applied as a matter of course to investment management. And increasingly, problems in corporate finance are also benefiting from the same techniques. The response promises to be no less heated. CAPM, the capital asset pricing model, embodies the theory. For financial executives, the proliferation of CAPM applications raises these questions: What is CAPM? How can they use the model? Most important, does it works? CAPM, a theoretical representation of the behaviour of financial markets, can be employed in estimating a companys cost of equity capital. Despite limitations, the model can be a useful addition to the financial managers analytical tool kit. The burgeoning work on the theory and application of CAPM has produced many sophisticated, often highly complex extensions of the simple model. But in addressing the above questions we shall focus exclusively on its simple version.

CAPITAL ASSETS PRICING MODEL

CAPM establishes that the required rate of return of a security is related to its contribution to the risk of the portfolio. It stresses that only the systematic risk, the undiversifiable risk, is relevant for the expected return of the security. Since the diversifiable risk, i.e., the unsystematic risk can be eliminated; there is no reward for it.

Assumptions of CAPM:
CAPM starts with the question, what would be the risk premiums on securities if the following assumptions were true? The market prices are in equilibrium. In particular, for each asset, supply equals demand. All investors chose portfolios optimally according to the principles of efficient diversification. This implies that everyone holds the tangency portfolio of risky assets as well as the risk-free asset. Only the mix of the tangency portfolio and the risk-free varies between investors The investors are basically risk averse and diversification is needed to reduce the risk. All investors want to maximise the wealth and choose a portfolio solely on the basis of risk and return investment. All investors can borrow or lend an unlimited amount of funds at risk free rate of interest. All investors have identical estimates of risk and return of all securities. All securities are perfectly divisible and liquid and there is no transaction cost or tax. The security market is efficient and purchases and sales by a single investor cannot affect the prices. This also means that there is perfect competition in the market. All investors are efficiently diversified and have eliminated the unsystematic risk. Thus only the systematic risk is relevant in determining the estimated return.

APPLYING THE CAPM: CAPM PRINCIPLES

Despite limitations, the Capital Asset Pricing Model remains the best illustration of long-term tradeoffs between risk and return in the financial markets. Although very few investors actually use the CAPM without modification, its principles are very valuable, and may function as a sufficient guide for the average long-term investor.
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These principles may be stated as: 1. Diversifythere is no compensation for unsystematic risk. 2. Hold long termdo not worry about timing when to get in or out of the market. 3. To earn a higher return, take on more systematic risk. The more stocks one holds that are sensitive to the business cycle the more average return the portfolio will receive. For shorter term, or more sophisticated investing, other models have been developed. However, unless the model is based on market inefficiencies, or obtaining superior information, it will still have the CAPM basic tenets at its center.

CAPM AND RISK

Risk in investment analysis means that the future returns from an investment are unpredictable. The concept of risk may be defined as the possibility that the actual return may not be the same as expected. Diversification will reduce risk but will not remove all of the risk. So, there are effectively two kinds of risk

Systematic risk

Unsystema tic risk

RISK

Diversifiable/nonsystematic/idiosyncratic risk: Unsystematic risk, also known as "specific risk," "diversifiable risk" or "residual risk," is the type of uncertainty that comes with the company or industry you invest in. Unsystematic risk
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can be reduced through diversification. For example, news that is specific to a small number of stocks, such as a sudden strike by the employees of a company you have shares in, is considered to be unsystematic risk. It disappears without cost, i.e. you need not sacrifice expected return to reduce this type of risk. The key is that these events are random and unrelated across firms. For the assets in a portfolio, some surprises are positive, some are negative. On average, across assets, the surprises offset each other if your portfolio is made up of a large number of assets. Examples Lawsuits Technological innovations Labor strikes

Nondiversifiable/systematic/market risk: Systematic risk, also known as "market risk" or "un-diversifiable risk", is the uncertainty inherent to the entire market or entire market segment. Also referred to as volatility, systematic risk consists of the day-to-day fluctuations in a stock's price. Volatility is a measure of risk because it refers to the behavior, or "temperament," of your investment rather than the reason for this behavior. Because market movement is the reason why people can make money from stocks, volatility is essential for returns, and the more unstable the investment the more chance there is that it will experience a dramatic change in either direction. Examples: Business Cycle Inflation Shocks Productivity Shocks Interest Rate Changes Major Technological Change

WORKING OF CAPM
The CAPM attempts to explain and provide the mechanism whereby investors can assess the impact of a proposed security on their portfolios risk and return. The total risk of a portfolio can be bifurcated into two types: 1) Systematic risk (which cannot be eliminated and is correlated with that of the market portfolio) 2) Unsystematic risk (which can be eliminated by more and more diversification) A portfolio is efficient if there is no unsystematic risk. Therefore, the only effect a security has on the portfolio risk is through the systematic risk. The risk of a diversified portfolio depends upon the systematic risks of the securities included in the portfolio. An investor, therefore, will be interested to know the effect each security will have on the risk of his portfolio. All the securities available to an investor do not have same level of systematic risk; the factors contributing to systematic risk do not affect all the securities in the same way. The magnitude of the influence of these factors varies from one security to another depending upon the sensitivity of the security to the market fluctuations. The investor will receive risk-premium only for the systematic risk as it is non-diversifiable.
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Now, the CAPM can be expressed in terms of the following equation: RS = IRF + (RM IRF) Where RS = the expected return from a security/asset, IRF = the risk-free interest rate RM = the expected return on market portfolio, and = the beta factor, a measure of systematic risk of the security/asset. The portfolio that contains all the securities in the economy is called the market portfolio, and it plays a crucial role in CAPM. The model depicts that the expected rate of return of a security consists of two parts, i.e. a.) The risk-free interest rate and b.) The risk premium The risk premium is equal to the difference between the expected market return and the risk free interest rate multiplied by the beta factor. Evidently, the risk premium varies directly with the beta factor, i.e. the systematic risk and therefore the value of expected returns from a security depends upon the beta factor. The higher the beta factor, the greater is the expected rate of return, and vice-versa. The CAPM can also be presented as: Expected return = Price of time + Price of risk Amount of risk = Risk-free Rate + Risk-premium What the CAPM shows is that the expected return for a particular security depends on three things: 1.) The pure time value of money: As measured by the IRF, this is the reward for merely waiting for your money without taking any risk 2.) The amount of systematic risk: As measured by , this is the amount of systematic risk present in the particular security, in relation to that present in an average security.

3.) The reward for bearing systematic risk: As measured by the market risk premium, (RM IRF) , this component is the reward, the market offers for bearing an average amount of systematic risk in addition to waiting. In CAPM, is the measure of volatility of systematic risk of a security in the portfolio. It measures how sensitive the price of a security is to the market movements. In other words, is a measure of performance of a particular security in relation to the general movement of the index. It measures the securitys marginal contribution to the risk of the market portfolio. It may be noted that the securities whose beta factor is greater than 1 will tend to amplify the overall movement of market rate of return; and the securities whose beta factor is less than 1will tend to move in the same direction as the market. If a security has a beta factor of 1, it indicates that the rise or fall in the price will correspond exactly with the index. For example, if the is 2 and the index rises by 10%, then the price of that security is likely to rise by 20%. Since the market consists of all the securities and is a portfolio of securities, an average security will have a beta factor of 1 only. Thus, the CAPM helps in establishing the relation between the risk and the return.

CAPITAL MARKET LINE

CML represents the equilibrium condition that prevails in the market for portfolios consisting of risk-free and risky investments. All combinations of risky and risk-free investments are bound by the CML and in equilibrium. All investors will end up with portfolio on the CML. The CML may be obtained by drawing a line which is tangent to the efficient frontier and is passing through IRF, the risk-free rate of interest If there is no risk-free investment, then the investors will hold portfolio M as their optimal risky portfolio In the presence of risk-free investments, All investors will be somewhere on

this

line

(CML)

SECURITY MARKET LINE (SML)

The graphical version of CAPM is called Security market line (SML). The SML represents the relationship between the beta factor and the expected rate of return of a security.

APPLICATIONS OF CAPM
The CAPM has a variety of uses: For valuation of risky assets: As an analyst, you could use CAPM to decide what price you should pay for a particular stock. If Stock A is riskier than Stock B, the price of Stock A should be lower to compensate investors for taking on the increased risk. For estimating required rate of return of risky projects Portfolio selection: According to CAPM, all investors should hold the market portfolio, leveraged or de-leveraged with positions in the risk-free asset. CAPM also introduced beta and relates an assets expected return to its beta. Identifying Mispriced shares Measuring portfolio performance

It provides a theoretical justification for the widespread practice of passive investing known as indexing. Indexing means holding a portfolio similar to a broad market index such as the S&P 500. Individual investors can just buy an index fund.

CAPM can establish fair rates of return on invested capital in regulated firms or in firms working on a cost-plus basis. What should the plus be? CAPM is most often used to determine what the fair price of an investment should be. When you calculate the risky asset's rate of return using CAPM, that rate can then be used to discount the investment's future cash flows to their present value and thus arrive at the investment's fair value.

By extension, once you've calculated the investment's fair value, you can then compare it to its market price. If your price estimate is higher than the market's, you could consider the stock a bargain. If your price estimate is lower, you could consider the stock to be overvalued.

CRITICISM/LIMITATIONS OF CAPM:
There have been a number of criticisms of CAPM, including: The calculation of beta factor is very tedious as lot of data is required. The beta factor may or may not reflect the future viability of returns. The beta factor cannot be expected to be constant over time. It must be updated frequently. The assumptions of the CAPM are hypothetical and are impractical. For example, the assumption of borrowing and lending at the same rate is imaginary. In real practice, the borrowing rates are higher than the lending rates. The actual working of the stock market doesnt follow the theory particularly well. The required rate of return, Rs, specified by the model can be viewed only as a rough approximation of the required rate of return. The statistical methods only work under the assumption that risky-asset returns are arranged in an orderly normal pattern. At least as far as the stock market is concerned, theyre not.

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REFERENCES
Websites: Books: Rustagi R.P., Investment Management Bhalla V.K., Investment management http://www.readyratios.com/reference/analysis/capital_asset_pricing_model_capm .html http://www.letslearnfinance.com/capital-asset-pricing-model-and-itsassumptions.html http://www.investopedia.com/walkthrough/corporate-finance/4/returnrisk/systematic-risk.aspx http://hbr.org/1982/01/does-the-capital-asset-pricing-model-work/ar/8 http://kalyan-city.blogspot.com/2012/01/types-of-risk-systematic-and.html http://www.referenceforbusiness.com/encyclopedia/Bre-Cap/Capital-AssetPricing-Model-CAPM.html http://www.differencebetween.net/business/difference-between-cml-and-sml/

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