FNCE10002 Lecture Notes - Lecture 8: Systematic Risk, Standard Deviation, Risk Premium
19 Jun 2018
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Principles of Finance
Lecture 8- Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM)
The CAPM is a theoretical model used to ‘price’ individual securities. The CAPM relates a security required
return to its non-diversifiable or systematic risk. The higher the systematic risk, the higher the required or
expected rate of return.
“Pricing” a security here means estimating its required rate of return (using the CAPM) and then obtaining
a price estimate based on the security’s future expected cash flows (dividends and future price).
Total risk is not relevant to pricing securities, or portfolios of securities
The Capital Market Line (CML) is able to price only efficient portfolios,
and is unable to graph inefficient securities. The Capital Asset Pricing
Model (CAPM) is able to ‘price’ both.
In the example aside, according to CAPM, securities A and B will have
the same expected return because they have the same systematic risk
level.
Although A has a much higher total risk level (greater standard
deviation), this is irrelevant.
CAPMs Main Assumptions
- Investors are risk adverse and want to maximise the expected utility of their end-of-period wealth.
- Investor decisions are made based off expected return and return variance.
- Expectations about security returns are identical among investors.
- Returns of securities follow a normal distribution.
- Capital markets are perfect
- There is unlimited borrowing and lending at the risk-free rate
- The set of risky securities is set and all securities are traded.
The CAPM’s Intuition
- All investors hold efficient portfolios (made from the market portfolio, M, and the risk-free security.
- Investors who don’t diversify gain no increase in expected return for bearing this additional
(diversifiable) risk.
- Any security, A, is held a part of M and has an expected return which reflects its contribution to the
non-diversifiable risk of the market portfolio. This contribution depends on its covariance with the
market portfolio and not its own risk (SD).
- CAPM can be written as:
The amount of risk is measured by the covariance of the security with the market portfolio (the beta of the
security, )
The market price of risk is the return above the risk-free rate that investors earn for holding the (risky)
market portfolio.
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
The capm is a theoretical model used to price" individual securities. The capm relates a security required return to its non-diversifiable or systematic risk. The higher the systematic risk, the higher the required or expected rate of return. Pricing a security here means estimating its required rate of return (using the capm) and then obtaining a price estimate based on the security"s future expected cash flows (dividends and future price). Total risk is not relevant to pricing securities, or portfolios of securities. The capital market line (cml) is able to price only efficient portfolios, and is unable to graph inefficient securities. In the example aside, according to capm, securities a and b will have the same expected return because they have the same systematic risk level. Although a has a much higher total risk level (greater standard deviation), this is irrelevant. Investors are risk adverse and want to maximise the expected utility of their end-of-period wealth.
