Capital Asset Pricing Model and its Uses
1. The risk of any stock can be divided into two components that are relevant to investors. The first risk component is diversifiable risk and the other component is a market risk or systematic risk. The diversifiable risk of a stock can be avoided and is caused by random events such as marketing program success, lawsuits, strikes, and lockouts. We have to consider the fact that the diversifiable risk is associated with and affects a specific company. Market risk on the other hand affects the whole market and cannot be avoided and is caused by factors such as interest rate hike, inflation, recession, and other factors affecting the entire market).
- a. A large fire severely damages three major U. S. cities Systematic Risk This is a market risk or systematic risk as it would affect the whole market and not a particular company as we saw in the aftermath of 9/11 the whole market was affected by incidents in major cities of the U. S. This risk cannot be avoided or eliminated as the fire in the major cities would eventually affect the entire market and it is not related to a specific industry or company.
- b. A substantial unexpected rise in the price of oil Systematic Risk This is also a systematic risk as it would affect many companies directly and indirectly. It was mentioned earlier that the risk affecting the entire market is systematic risk and is not diversifiable. The rise in oil prices affects the entire economy as a whole and not just some specific companies as we have seen in recent years.
- c. A major lawsuit is filed against one large publicly traded corporation Diversifiable Risk As discussed earlier the risk affecting specific companies instead of the entire market is diversifiable and can be avoided. The lawsuit is against one company and would only affect the company involved in the lawsuit therefore it is a diversifiable risk.
2. Capital Asset Pricing Model – CAPM The Capital Asset Pricing Model is a technique to explore the relationship between the rate of return and risk of a stock. The technique involves the following equation (Brigham & Ehrhardt, 2001): rs = rRF + (rm – TRF). Where rs is the rate of return on stock rRF is the risk-free rate rm is the expected return on market portfolio bi is the beta coefficient of a stock
- a. Expected rate of return on asset = 10% Risk free rate = 3% Beta = 1. 5 Expected rate of return on market portfolio =? rs = rRF + (rm – rRF) bi 10% = 3% + (rm – 3%) 1. 5 10% – 3% = (rm – 3%) 1. 5 7% = (rm – 3%) 1. 5 7% / 1. 5 = rm – 3% 4. 67% = rm – 3% 4. 67% – 3% = rm rm = 1. 67 % The expected rate of return on market portfolio is 1. 67 percent.
- b. Expected rate of return on asset = 14% Expected rate of return on market portfolio = 12% Beta = 1. 5 Risk free rate =? rs = rRF + (rm – rRF) bi 14% = rRF + (12% – rRF) 1. 5 14% = rRF + 18% – 1. 5rRF 14% – 18% = rRF – 1. 5rRF -4% = -0. 5rRF rRF = 4% / 0. 5 rRF = 8% The risk free rate is 8%.
- c. The market risk of any portfolio is estimated through the beta coefficient of that portfolio. The beta of the portfolio would be 1. 0 if half of all the stocks traded on major exchanges are owned. A portfolio having 1. 0 beta means that the portfolio risk is similar to the market risk. If the market rises or falls the value of the portfolio shall follow the market. If the beta coefficient is higher than 1. 0 it means the portfolio is riskier than the market and if is lower than 1. 0 it means it is less risky than the market. The weighted average beta of all the stocks included in a portfolio is taken to estimate the beta of the portfolio. If we own half of all the stocks the weighted average would be 1.0 as our portfolio includes half of every stock traded in the market.
3. Capital Asset Pricing Model for Corporations and Investors The Capital Asset Pricing Model is an approach of measuring and comparing the relationship between the rate of return and the risk of a particular stock or portfolio. The calculation and estimation of CAPM are very beneficial to investors, analysts and corporations. Corporations apply the model to estimate the cost of capital which is also the required rate of return for the investors. The cost of capital is very beneficial for corporations to estimate the capital budgets and selecting from the different financing modes available. The corporations can estimate the returns expected by investors while issuing new stock. When the rate of return has been estimated a company can analyze and plan to meet this rate in order to raise capital by issuing shares. As an example suppose the rate of return on a stock calculated through CAPM is 10%, the company would have to offer stock which has a higher or similar rate of return. This rate of return of investors is the cost of common stock for the corporations. The Capital Asset Pricing Model is also of much significance to investors as the investors can test the risk and return involved in a stock with respect to market conditions. The concept of diversifiable and systematic risk is derived from this model. The model helps investors in identifying how risk can be diversified and eventually eliminated. An important component of CAPM is the beta coefficient of a stock or portfolio which measures the riskiness of that stock or portfolio with respect to the market.
For example, if a stock has a beta of 1. 5 and another stock has a beta of 0. 5 the first stock is riskier than the second stock. The portfolio beta can be tested by calculating the beta coefficient of the stocks in the portfolio through the weighted average beta of the stocks. If the risk is high then some stocks can be substituted with other stocks of lower beta to decrease the riskiness of the entire portfolio.
Reference
- Brigham, E., & Ehrhardt, M. (2001).
- Financial Management: Theory and Practice 11th Edition. Florence: South-Western Educational Publishing.
