CAPM
The capital asset pricing model shows us the return of an investment by using systematic
risk.
This can be calculated as:
E(r) = Rf + Beta (Rm – Rf)
E(r) = expected return
Rf – risk free rate
Rm – Return in the market.
Rm – Rf – is the market risk premium – sometimes they will give you the market risk
premium and not the return in the market.
E(r) = 𝐴̅ × 𝜎𝑀
2
+rf - here we are calculating the return of a portfolio.
A = is the degree of risk for an investor
2
𝜎𝑀 = is the standard deviation
∝ - This is alpha, and it is the difference between the actual return and the expected return of
a portfolio.
∝ = E(r) – [ rf – B (Rm – Rf)]
- If alpha is positive, it means the portfolio will earn abnormal returns.
ARBITAGE PRICING THEORY
Includes more than one factor of risk in the equation.
Ri = 𝜆0+∑𝛽𝑖𝜆𝑖
𝜆0 – is the risk-free rate
𝜆𝑗 - is the risk premium for each factor that corresponds to the Beta.
ADDITIONAL INFORMATION
Treasury bills are paying a 4% rate of return. A risk-averse investor with a risk
aversion of A = 3 should invest entirely in a risky portfolio with a standard deviation of
24% only if the risky portfolio's expected return is at least ________.
A. 8.67%
B. 9.84%
C. 21.28%
D. 14.68
𝐸(𝑟𝑚)−𝑅𝑓
- Formula = 𝐴̅ = 2
𝜎𝑚
- A – risk aversion for an investor
- Rf – is the risk-free rate.
- E(rm) – return in the market.
2
- 𝜎𝑀 = is the standard deviation.
2
Hence A = 3, Rf = 4%, 𝜎𝑀 = 24%.
We need to solve E(Rm), The formula needs to be manipulated:
𝐸(𝑅𝑚 ) = 𝐴̅ × 𝜎𝑚
2
+ 𝑅𝑓
1. Kyle Co. achieved net income of R12 million rand last year. The firm has 30 million
shares in issue and a payout ratio of 25%. Historical ROE is 22%. If you require a return
of 20% how much would you be prepared to pay for this share?
2. You are told by your investment advisor that Laduma Co. is expected to earn R5 per
share next year, R6 per share the following year and that thereafter earnings are
expected to grow by 8 percent per year. The dividend payout ratio is 60 percent and the
required rate of return on Laduma shares is 15 percent. If the current share price is R40,
would you expect your adviser to make a buy, hold or sell recommendation? If
transaction costs are R2,50 per share, would you follow his advice?
3.
