CAPITAL ASSET PRICING MODEL

1 Introduction

CAPM is a technique that is used to establish the required rate of return of an investment given a
particular level of risk.
Definition:
A portfolio is a combination of assets held by the investor for investment purposes. Portfolio theory
therefore attempts to show an investor how to combine a set of assets to maximise the assets' returns as well
as minimize the assets' risk (Risk Diversification).
EFFICIENT SET OF INVESTMENT
If consider many assets, the feasible set of investment will be given by the following graph

The shaded area is the attainable set of investment. However, investors will invest in a portfolio with the
highest return at a given risk or the lowest risk at a given return. The efficient set of investment, therefore,
will be given by the frontier B C D E. This frontier is referred to as the Efficient Frontier.
Any point on the efficient frontier dominates all the other points on the feasible set.
2 What is business risk?

Why is it that some shares in some companies are viewed as inherently more risky than shares in other
companies? It is because the nature of their business is more risky. As a result, the potential
fluctuations in profits (and hence dividends) in the future are greater. If things go well shareholders
maywell receive much higher dividends, but the risk is that things may go badly in which case they will
receive much lower dividends. The greater the potential fluctuations in returns, the greater we say that
the risk is.

3 Two types of business risk

There are two different reasons why one company may be more risky than another.

Systematic Risk – This is the risk that affects all the firms in the market. This risk cannot be
eliminated/diversified. It is thus called undiversifiable risk. Since it affects all the firms in the market,
the share price and profitability of the firms will be moving in the same direction i.e. systematically.
Examples of systematic risk are political instability, inflation, power crisis in the economy, power
rationing, natural calamities – floods and earthquakes, increase in corporate tax rates and personal tax
rates, etc. Systematic risk is measured by a Beta factor.

Unsystematic risk – This risk affects only one firm in the market but not other firms. It is therefore
unique to the firm thus unsystematic trend in profitability of the firm relative to the profitability trend of
other firms in the market. The risk is caused by factors unique to the firm such as:

 Labour strikes by employees of the firm;

 Exit of a prominent corporate personality;
 Collapse of marketing and advertising programs of the firm on launching of a new product;
 Failure to make a research and development breakthrough by the firm, etc
 The investor therefore seeks to eliminate the diversifiable risk. This can be shown below:
 Diversification of Risk

 From the graph shown above as the number of assets increases, the portfolio risk reduces up to
point M. At this point the lowest risk has been achieved and adding more assets to the portfolio
will not reduce the portfolio risk.
 An efficient portfolio therefore is well diversified portfolio.
 Note: The non-diversifiable risk can also be referred to as the market risk.
CAPM is only concerned with systematic risk. According to the model, the required rate of return will be
highly influenced by the Beta factor of each investment. This is in addition to the excess returns an
investor derives by undertaking additional risk e.g cost of equity should be equal to R f + (Rm – Rf)BE

Cost of Equity(ke) = Rf + (Rm – Rf)Bd

Where: Rf= rate of return/interest rate on riskless investment e.g T. bills
Rm = Average rate of return for the entire stock as shown by average
Percentage return of the firms that constitute the stock index.
Be = Beta factor of investment in ordinary shares/equity.
Bd = Beta factor for investment in debentures/long term debt capital.
ASSUMPTIONS OF CAPITAL ASSET PRICING MODEL

 The capital market is assumed to be efficient i.e prices reflect all the relevant information
 The capital markets are assumed to be perfect i.e there are no taxes and no transaction costs
  Investors are assumed to be risk averse i.e they will be willing to take an additional risk if that
additional risk is accompanied by increase in returns.
 The expected returns of the securities are assumed to follow the normal distribution
 Investors decisions are based on a single time period
 Investors decisions are assumed to borrow and lend at the risk-free return
 Investors are assumed to have similar expectations about the returns expected and risk of
securities

4 Measurement of systematic risk There are several ways in which we could attempt to measure the
systematic risk of an investment, but the standard way is to measure it relative to the risk of the stock
exchange as a whole. The stock exchange index is the average of all the shares on the stock exchange,
and is risky (in that it fluctuates). Some shares fluctuate more that the average, whereas some fluctuate
less that the average.

We use β to measure the systematic risk, and β is defined as being the systematic risk of the investment
as a proportion of the risk of the market (or stock exchange) as a whole.

If an investment has a β of 1, it has 1 times the risk of the market – i.e. it has the same risk as
the market.

If an investment has a β > 1, then it is more risky than the market.

If an investment has a β < 1, then it is less risky than the market.

If an investment has a β of 0, then it has zero risk, or we say that it is risk-free.

In practice, no investment is completely without risk, but we assume that short-term government
securities are effectively risk-free.

5 The determination of the required return from an investment

As stated earlier, we assume that investors overall are well-diversified, and that therefore it is the level
of systematic risk that will determine the required return.

The following formula is given to you in the examination: E(ri)=Rf + βi (E(rm) – Rf )

where:

Rf = the risk-free rate, and

E(rm) = the return from the market

If we graph ßi and E(Ri) then we can observe the following relationship

All correctly priced assets will lie on the security market line. Any security off this line will either be
overpriced or underpriced. The security market line therefore shows the pricing of all asset if the market is
at equilibrium. It is a measure of the required rate of return if the investor were to undertake a certain
amount of risk.
Ex a m p l E 1

Q plc has a β of 1.5. The market is giving a return of 12% and the risk-free rate is 5%

What will be the required return from Q plc?

ex a m p l E 2 R plc has a β of 0.8. The market is giving a return of 16% and the risk free rate is 8%.
What will be the required return from R plc?

Ex a m p l e 3

S plc is giving a return of 20%. The stock exchange as a whole is giving a return of 25%, and the return on
government securities is 8%.

What is the β of S plc?

Example 4
KK Ltd is an all-equity firm whose Beta factor is 1.2, the interest rate on T. bills is currently at 8.5% and
the market rate of return is 14.5%. Determine the cost of equity Ke, for the company.

Solution
Rf = 8.5% Rm = 14.5% Beta of equity = 1.2
Ke = Rf + (Rm– Rf)BE
= 8.5% + (14.5% - 8.5%) 1.2
= 8.5% + (6%)1.2
= 15.7%

6 Using CAPM for investment appraisal

If the financial manager is considering an investment in a new project, then since it is shareholders
money that is being invested, he should appraise the investment in the same way as would
shareholders if they were investing their money directly.

As a result the required return from the project (and hence the discount rate) should be calculated from
the β of the project.

LIMITATIONS OF CAPM
CAPM has several weaknesses e.g.
a. It is based on some unrealistic assumptions such as:
i. Existence of Risk-free assets
ii. All assets being perfectly divisible and marketable (human capital is not divisible)
iii. Existence of homogeneous expectations about the expected returns
iv. Asset returns are normally distributed.
b. CAPM is a single period model—it looks at the end of the year return.
c. CAPM cannot be empirically tested because we cannot test investors expectations.
d. CAPM assumes that a security's required rate of return is based on only one factor (the stock market
—beta). However, other factors such as relative sensitivity to inflation and dividend payout, may
influence a security's return relative to those of other securities.
The Arbitrage pricing theory is designed to help overcome these weaknesses.
ARBITRAGE PRICING THEORY (APT)
Formulated by Ross(1976), the Arbitrage Pricing Theory(APT)offersa testable alternative to the capital
market pricing model(CAPM). The main difference between CAPM and APT is that CAPM assumes that
security rates of returns will be linearly related to a single common factor- the rate of return on the market
portfolio. The APT is based on similar intuition but is much more general.

APT assumes that, in equilibrium, the return on an arbitrage portfolio (i.e. one with zero investment, and zero
systematic risk) is zero. If this return is positive, then it would be eliminated immediately through the process
of arbitrage trading to improve the expected returns. Ross (1976) demonstrated that when no further arbitrage
opportunities exist, the expected return (E(Ri)) can be shown as follows:

E(Ri)=Rf + β1(R1-Rf)+β2(R2 -Rf)+--------+ βn(Rn-Rf)+έi

Where, E(Ri) is the expected return on the security

Rfis the risk free rate

Βiis the sensitivity to changes in factor i

έiis a random error term.

3.2 APT and CAPM compared

The Arbitrage Pricing Theory (APT) is much more robust than the capital asset pricing model for several
reasons:

a) The APT makes no assumptions about the empirical distribution of asset returns. CAPM assumes
normal distribution.
b) The APT makes no strong assumption about individuals’ utility functions (at least nothing stronger
than greed and risk aversion).
c) The APT allows the equilibrium returns of asset to be dependent on many factors, not just one (the
beta).
d) The APT yields a statement about the relative pricing of any subset of assets; hence one need not
measure the entire universe of assets in order to test the theory.
e) There is no special role for the market portfolio in the APT, whereas the CAPM requires that the
market portfolio be efficient.
f) The APT is easily extended to a multi-period framework.

Since APT makes fewer assumptions than CAPM, it may be applicable to a country like Kenya.
However, the model does not state the relevant factors. Cho(1984) has, however, shown the security
returns are sensitive to the following factors: Unanticipated inflation, Changes in the expected level of
industrial production, Changes in the risk premium on bonds, and Unanticipated changes in the term
structure of interest rates
Illustration
Security returns depend on only three risk factors-inflation, industrial production and the aggregate degree
of risk aversion. The risk free rate is 8%, the required rate of return on a portfolio with unit sensitivity to
inflation and zero-sensitivity to other factors is 13.0%, the required rate of return on a portfolio with unit
sensitivity to industrial production and zero sensitivity to inflation and other factors is 10% and the required
return on a portfolio with unit sensitivity to the degree of risk aversion and zero sensitivity to other factors is
6%. Security i has betas of 0.9 with the inflation portfolio, 1.2 with the industrial production and-0.7 with
risk bearing portfolio—(risk aversion)
Assume also that required rate of return on the market is 15% and stock i has CAPM beta of 1.1
REQUIRED:
Compute security i's required rate of return using
a. CAPM
b. APT
Using APT

E(Ri)=Rf + β1(R1-Rf)+β2(R2 -Rf)+--------+ βn(Rn-Rf)+έi

Ri = 8% + (13% - 8%)0.9 + (10% - 8%)1.2 + (6% - 8%)(-.7)

= 16.3%
Using CAPM Ri = RF + (E(RM) - RF)ßi

Ri = 8% + (15% - 8%)1.1 = 15.7%

3.3 LIMITATIONS OF APT

APT does not identify the relevant factors that influence returns nor does it indicate how many factors
should appear in the model. Important factors are inflation, industrial production, the spread between low
and high grade bonds and the term structure of interest rates.