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INTRODUCTION:

Modern finance theory provides a theoretical representation of the


way risky financial assets are priced in the market. Capital Assets
Pricing Model (CAPM) is the theory developed and modified by the
financial economists through the sixties - W. Sharpe and J. Tobin. It
can be applied to all capital assets such as shares, debentures,
bonds, etc.

CAPM EQUATION:
CAPM is that the expected return of an asset which will be related
to a measure of risk for that asset known as beta. CAPM specifies
the manner in which expected return and beta are related. It
provides the intellectual basis for a number of the current practies
in the investment.
according to CAPM, the relation between Risk and Return is
Ki=Rf + $(Km - Rf)
where Ki = Required or expected rate of return on security
Rf = Risk free rate of return
$ = Beta coefficient of a security
Km = Expected rate of return on market portfolio
Return: Return from an investment is the realisable cash flow
earned by its owner during a given period of time. for example, a
security is purchased for rs. 80. The investor gets dividend of rs. 2
per share and market price after one year is rs. 90. What is the
return?
The Rate of Return = Total Return/investment * 100
Total Return = Dividend + Capital appreciation
= Rs. 2 + 10(90-80)
1

= Rs. 12
Rate Of Return = 12/80 *100
= 15

Expected Rate Of Return: It is the average return that one


expects to receive on an investment over the long term. thr
expected rate of return is calculated.
For example, the rate of return and their probabilities for B ltd.
Are given below
State of economy
Probability
Rate of return
Boom
0.30
25%
Normal
0.50
20%
Recession
0.20
15%
Calculate the expected rate of return.
K = (0.30*25%) + (0.50*20%) + (0.20*15%)
=7.5 + 10 + 3
=20.5%
Market portfolio: it is the portfolio comprising of all the risky
securities that are traded in the market.
Risk : it means chance of loss. It refers to the variability of
possible returns associated with an investment. The greater the
dispersion of possible return, the greater the risk and vice-versa.
There are different type of risk such as default risk, business risk,
financial risk, purchasing power risk, interest rate risk. All these
risk can be classified as systematic risk and unsystematic risk.
Systematic risk is external risk which cannot be diversified and
investors cannot avoid the risk arising from the above factor.
However, unsystematic risk is internal to the company and it can
be diversified by combining the securities in the portfolio.
Risk also refers to the dispersion of a probability distribution. How
much do individual outcomes deviate from the expected value? A
simple measure of dispersion is the range of possible outcomes
2

which is simply the difference between the highest and lowest


outcome.

Where p1 = probability associated with the occurrence


K1 = possible rate of return
K = expected rate of return
N = number of possible outcomes
Calculation of standard deviation of rates of return of B ltd. In
the above example is as follows.
State of
K1%
(k1-k)
(k1-k)2
P1
P1(k1-k)2
economy
Boom
25
4.5
20.25
0.30
6.075
20
0.5
0.25
0.50
0.125
15
-5.5
30.25
0.20
6.050
12.25
Beta: Beta is a measure of performance of a particular share or
class of shares in relation to the general movement of the market.
Beta 1, rise or fall is double. The systematic or non-diversifiable
risk of a security is generally measured by beta. This represents
the extent to which the returns on security fluctuates in response
to change in the market rate of returns. If a share has consistently
risen more than the market as a whole it has a debt of more than
1. In future also, this share can be expected to rise at a higher
rate than the market as a whole. On the other hand, if the market
falls, this share will crash by greater than the market as a whole.
Beta is calculated statistically by dividing the co-variance
between a particular securitys return and the market rate of
return by the variance of return on the market index.