Handout 05 Risk & Return Capital Asset Pricing Model [CAPM]

Systematic Risk

Systematic risk is the variability in security returns caused by changes in the economy risk that remains after diversification is market risk. Market risk of a security stems from the influence of certain economy-wide factors like money supply, inflation, level of government spending and industrial policy.

These factors affect returns on all firms. Investors cannot avoid the risk arising from them.
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All securities are affected by such changes to some extent, but all securities do not have the same degree of non diversible risk Because the magnitude of influence of economy wide factors tends to vary from one firm to another.

Different securities have different sensitivities to variations in market return.

Beta The systematic risk of a security is measured by a statistical measure called beta. Beta is an index of the systematic risk of an asset.
Beta measures fluctuation of return on a financial asset with return on

the market portfolio.

By definition the beta for the market portfolio () is 1. Individual

securities beta generally falls in the range 0.06 to 1.80.

In using this beta for investment decision making, the investors is

assuming that the relationship between the security variability and market variability will continue to remain the same in future also.
Beat is calculated from historical data of returns to measure the

systematic risk of a security. It is a historical measure of systematic risk 4

Capital Asset Pricing Model (CAPM)

The capital asset pricing model gives the nature of the relationship between the expected return and the systematic risk of a security.
The CAPM model is based on the proposition that any shares required rate of return is equal to the risk free rate of return plus its risk premium. Capital asset pricing model is mainly concerned How systematic risk is measured How systematic risk affects required rate of returns and share prices.

The model assumes that the linear relationship exists between risk and return[the higher the beta and the greater the required rate of return.
The linear relationship is defined by SML
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Kj = Rf + j (Km - Rf)
Kj: required/expected rate of return on security j Rf: risk free rate of return j: beta coefficient of security j Km: expected rate of return on the market portfolio (Km - Rf): Risk premium[the additional return required to compensate investors for assuming a given level of risk

Implication of CAPM Investors require return in excess of the risk free rate to compensate them for systematic risk Investors should not require a premium for unsystematic risk because this can be diversified by wide range of portfolio. Investors will require a higher return from shares when the systematic risk is high. 6

Security Market Line (SML) The graphical representation of CAPM is called the security market line. Security market line gives the relationship between systematic risk & return. The SML is often referred by the Kj = Rf + j (Km - Rf) Changes in Security Market Line The two parameters defining the security market line are - Rfintercept ((Rf) Slope (Km )

The intercept represents the nominal rate of return on the risk free security (risk free real rate of return plus inflation rate) The slope represents the price per unit of risk and is a function of the risk aversion of investors. If the real risk free rate of return and/or the inflation rate change, the intercept of the security market line changes. If the risk aversion of investors changes, the slope of the security market line also changes.

Application of the CAPM to project Appraisal

The capital asset pricing model was originally developed to explain how the returns earned on shares are dependent on their risk characteristics. its greatest potential use in the financial management of a company is in the setting of minimum required returns (risk adjusted discount rates) for new capital investment projects. The great advantage of using the CAPM for project appraisal is that it clearly shows that the discount rate used should be related to the projects risk.
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It is not good enough to assume that the firms present cost of capital can be used if the new project has different risk from the firms existing operations

Since, the cost of capital is simply a return which investors require on their money given the companys present level of risk, and this will go up if the risk increases.

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