CAPITAL ASSET

PRICING
MODEL
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 ✓ occurs when we invest in several different
Diversification assets rather than just a single one.

✓ The idea behind diversification is that, at times,

some investments will do well while some per
form poorly, and vice versa.
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 Systematic and Unsystematic Risk
Unsystematic Risk
● risk that can be diversified away as assets
are added to a portfolio; Systematic Risk
● also known as firm specific or industry- ● or market risk
specific risk ● risk that is inherent in the macro economy
and cannot be eliminated through
diversification.
● General financial market trends affect
most companies in similar ways.
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 Systematic and Unsystematic Risk
Unsystematic Risk
● risk that can be diversified away as assets
are added to a portfolio; Systematic Risk
● also known as firm specific or industry- ● or market risk
specific risk ● risk that is inherent in the macro economy
and cannot be eliminated through
diversification.
● General financial market trends affect
most companies in similar ways.
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 Total risk (portfolio variance) = systematic risk +
unsystematic risk
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 ● In a well-diversified portfolio, the only risk that remains is
the systematic risk.

● This means the only risk that should matter to financial

markets is systematic risk.

● When financial markets evaluate the trade-off between

risk and expected return, they focus on the trade-off
between systematic risk and expected return.
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 ● Assets with higher levels of systematic risk should have higher
expected returns; assets with lower levels of systematic risk
should have lower levels of expected returns.

● From this perspective, we see that an asset’s total risk is

unimportant. What is important is how the asset affects the
risk of the overall portfolio.

● Combining risky assets with a zero-risk asset will lower the

overall systematic risk of the portfolio.
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 CAPITAL ASSET
PRICING The CAPM states that the
MODEL expected return of an asset
depends upon its level of
systematic risk..
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 CAPM FORMULA
𝑅𝑖 = 𝑅𝑓 +𝛽 (𝑅𝑚 − 𝑅𝑓)

Where: 𝑅𝑖 = Expected Return

𝑅𝑓 = Risk-free rate
𝑅𝑚 = Market expected return
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𝛽 = Beta Coefficient
 CAPM FORMULA
𝑅𝑖 = 𝑅𝑓 +𝛽 (𝑅𝑚 −𝑅𝑓)

Market Risk Premium = (𝑅𝑚 −𝑅𝑓)

● It represents the extra expected return from investing in the
risky market portfolio rather than the risk-free asset.
● the slope of the security market line;
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Risk Premium = 𝛽 (𝑅𝑚 −𝑅𝑓)

 ● The asset’s systematic risk is
measured relative to that of the
market portfolio.
CAPITAL ASSET
PRICING ● Under the CAPM, beta (𝛽) is the
MODEL measure of an asset’s systematic
risk.

● It is important to note that beta is a

measure of relative risk and is not an
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absolute or total risk measure like

standard deviation.
 BETA
● Beta measures the volatility or variability of an asset’s returns relative to
the market portfolio.

○ Market Portfolio is the portfolio that contains all risky assets—all

stocks, bonds, real estate, and so on.
● The beta of the market portfolio, is 1.0. By definition, the market is exactly
as volatile as itself.
● Assets that are more volatile than the market, or equivalently, those that
have greater systematic risk than the market, have betas greater than 1.0.
● Assets that are less volatile than the market (that is, those with less
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systematic risk) have betas less than 1.0.

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 EXAMPLE
Suppose a particular stock has a risk-free rate of 5%, a rate of return on
the market of 12% and a beta coefficient (quantity of risk) of 1.5. What
would be the investor’s required rate of return?

𝑅𝑖 = 𝑅𝑓 +𝛽 (𝑅𝑚 − 𝑅𝑓)
𝑅𝑖 = 5% + 1.5 (12%-5%)
𝑅𝑖 = 5% + 10%
𝑅𝑖 = 15.5%
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 PORTFOLIO BETA
COEFFICIENT
● Portfolio beta coefficient can be computed as the weighted average of the individual
securities’ betas.

● The beta of the portfolio reflects how volatile the portfolio is in relation to the
market.
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 Example
An investor decided to invest his P350,000 as follows:

Amount %Allocation Beta

Diversified Stocks P200,000 57.1% 1.00
Bonds 100,000 28.6% 0.18
Treasury Bills 50,000 14.3% 0.00
Total P350,000 100.0%

The portfolio beta coefficient is:

With a market return of 11% and a risk-free rate of 5%, an investor can expect a
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return of:
 Example
An investor decided to invest his P350,000 as follows:

Amount %Allocation Beta

Diversified Stocks P200,000 57.1% 1.00 = 0.57
Bonds 100,000 28.6% 0.18 = 0.05
Treasury Bills 50,000 14.3% 0.00 = 0.00
Total P350,000 100.0% 0.62

The portfolio beta coefficient is:

With a market return of 11% and a risk-free rate of 5%, an investor can expect a
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return of: 𝑅𝑖 = 5% + 0.62(11%-5%) = 8.72%

 Security Market Line (SML)
● The CAPM is expressed graphically
by the security market line (SML).

● The security market line

represents the linear relationship
between a security’s required rate
of return and its risks as
measured by beta.
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