CAPITAL Asset Pricing Model

 Author: Prof. Jayapandian, Adjunct Professor, SMOT School of Business, Chennai

Investment is an art of choosing assets whose future intrinsic value is expected to be more than their present cost. When an investor wishes to invest in stocks, he has to find out

         a. The price at which he could acquire a stock or

         b. What is the rate of return a particular stock is expected to give.

The price he could pay for a stock is the expected rate of return the stock would give discounted by his desired rate of return. Suppose a particular stock is expected give a return of Rs. 15, and the desired rate of return of the investor is 10%,  then he would like to buy the stock for a price equivalent to or less than (≤) Rs. 150 ( 15 / .10 =1500). The desired rate of return of an investor is his opportunity cost or the weighted average cost of capital.

The return an investor expects from a stock differs based on whether the stock is quoted in the market or not. In case of unlisted companies, whose shares are not traded in stock exchanges, earning per share (EPS) is the basis for estimation. EPS is the net profit divided by the number of shares the company has issued and outstanding. EPS discounted by the desired rate of return would give the maximum price the investor would pay for that share. For example, the EPS of Solomon Services is Rs.11. The desired rate of return of an investor is 15%, he would be willing to pay a maximum price of Rs.73  (11/.15=73).

On the other hand, the expected return on a quoted share is calculated by using Capital Asset Pricing Model.  The formula was built on diversification and modern portfolio theory  of Harry Mrkowitz. Jack Treynor (1961, 1962), William Sharpe (1964), John Lintner (1965) and Jan Mossin (1966) independently formulated CAPM. Sharpe, Markowitz and Merton Miller jointly received Nobel Memorial Prize in economics for this contribution to the field of financial economics.

CAPM formula is simple and easy to work out. It runs as r= r_f+ β (r_m - r_f) ), where r is the desired rate of return, r_f is the risk free rate of return, β is the beta of a sock and r_m is the market rate of return. CAPM plays a vital role in assessing the desired rate of return of a security, having regard to its riskiness compared to market risk.

The minimum rate of return desired by an investor, who does not want to take any risk, is risk free rate of return. There is no security which is absolutely free from risk. But it is accepted that the 91 days treasury bills are near risk free. So, the return on 91 days treasury bills might be taken as risk free rate. Treasury bills are usually auctioned periodically. The auction price is indicated ex-interest, like the bills of face value of Rs,100 is auctioned at Rs.98.75. The investor in treasury bills thus would invest Rs.98.75 and on maturity would receive Rs.100. in other words the interest is deducted up front. In the above example, the risk free rate would work out to   5.08%(1.25/98.75/91*365*100= 5.08%).

Beta (β ) is the price sensitivity of a particular stock to the market price. Market price in the country is based on Sensex.  If the price of a particular stock moves in tandem with that of the market, its beta is 1 or unity. For example, if the market price (represented by Sensex) increases by 3.5%, or falls by 2.5% and the price of Reliance also increases by 3.5% or decreases by 2.5%, the beta of Reliance would be 1 or unity. In case the movement in the price of a stock is greater than that of the market, its beta is more than 1.For example, if the market price increases by 3% or decreases by 2%, and the price of WIPRO’s stock increases by 4.5% or decreases by 3%, the beta of WIPRO’s stock is 1.5 or greater than 1.On the other hand, if the movement in the price of a stock is less than that of the market, its beta is less than 1. For example, if the price of Hindustan Levers stock increases by 1.5% when the market prices have increased by 3% and decreased by 1% when the market price had decreased by 2%, then the beta of Hindustan Levers stock is 0.5 or less than 1.When the price of a security is unaffected by the market price movement, its beta is zero. A risk free investment security would thus have zero beta and a higher beta would indicate greater risk. Market risk premium is the difference between market rate and the risk free rate.

Thus, if the Sensex on a particular day changes from 17,145 to 17, 354 and the stock of an imaginary company, Radiant Reflectors, increased to Rs.308 from Rs.299, the β of Radiant Reflectors would work out to 2.37(change in sensex 1.27% and in Radiant Reflectors 3.01. β would be 3.01/1.27=2.37).risk free rate on that date is 5.48% and the market rate of return is 12%. The required return on Radiant Reflectors would thus be20.93 (5.48% +2.37(12%-5.48%=20.93%)

CAPM is thus a very handy formula for taking calculated investment decisions.