Lecture 17 - CAPM.pptVIP

CAPM: an introduction The CAPM is a method of share valuation developed by William Sharpe in 1964. It is based on a linear relationship between risk and return. It is a development of portfolio theory. It considers that systematic risk is the only relevant risk when valuing shares. CAPM assumptions Investors are rational utility maximisers. Information is freely available. All investors have similar expectations. Investors can borrow and lend at the risk- free rate. Investors hold diversified portfolios, thereby eliminating all unsystematic risk. CAPM assumptions Capital markets are perfect: No taxes or transaction costs Free entry and exit Many buyers and sellers Information is costless and freely available Single period transaction horizon Returns are calculated over a standard period Usually taken as 1 year Rf Systematic risk (β) 0 Return (%) βm= 1 Rm Rj = Rf + β j (Rm - Rf) The security market line βj Rj CAPM components Return of the market (Rm) Risk-free rate of return (Rf) Equity risk premium (Rm – Rf) Beta value of the ordinary shares of a company (βj) Meaning and calculation of beta Beta is seen as an ‘index of responsiveness’ of changes in a securitys returns relative to changes in returns on the market Example: BP’s equity beta = 0.75 Market return increases by 10% Return on BP’s shares increases by 7.5% Meaning and calculation of beta Beta can be found from: βj = (σj σm ρjm)/σm2 Where: σj = standard deviation of returns on asset j σm = standard deviation of market returns ρjm = correlation coefficient between j and m σm2 = variance of returns on the market Meaning and calculation of beta Beta can be found by regression analysis of security returns against market returns. Beta can be found from a line of best fit of a plotof security returns against market returns. Company beta values are found in the Beta Books published by the London Business School Risk Management Service and from other financial resources such as Datastream. 0 Secur