INVESTMENT ANALYSIS
Topic: Capital Market Theory
Like I said guys, let’s do more
theories – you never can tell, most students concentrate on calculations and on
the judgment day, simple theory will put them off;
For
questions and answers, email theotherwomaninmarriage@gmail.com
INTRODUCTION
The Capital Market Theory
developed from the work of William Sharpe (1964) was an extension of Henry
Markowitz portfolio theory. This is so
because Markowitz theory of portfolio attempts to describe how rational
investors are supposed to behave and to build an efficient portfolio.
The Capital Market Theory with
all intent and purpose deals with how securities are supposed to be priced and
what conditions are supposed to operate in an efficient capital market if
indeed every investor behave in the way suggested by the portfolio theory.
ASSUMPTIONS UNDERLINED THE CAPITAL MARKET THEORY
1.
That the rate of return from an investment
adequately summaries the outcome from the investment and that investors see
various possible rate of return in a probabilistic fashion.
2.
Investors risk estimate are proportional to the
variability of return they visualize.
3.
For every risk class, investors prefer higher
returns conversely; a group of securities with the same expected returns,
investors prefer less to more risk.
4.
Any amount of money can be borrowed or lend at
risk free rate
5.
That all investments are infinitely divisible i.e
fraction share can be purchased
6.
Information is cost less and is freely and
simultaneously available to all investors in other words no one investors can
take undue advantage over the other.
7.
That there are no market imperfection such as
taxes, regulation and transaction cost.
8.
There are no inflation and therefore no change
in interest rate level.
9.
That market is in a state of equilibrium – no excess
demand and no excess supply
CAPITAL ASSET PRICING MODEL (CAPM)
The Capital
Asset Pricing Model (CAPM) is a model that provides a framework to determine
the required rate of return on an asset and indicate the relationship between
return and risk of the asset. One can
also compare the expected (estimated) return on an asset with its required rate
of return and determine whether the asset is fairly valued. Under CAPM, the security market line (SML)
exemplifies the relationship between an asset’s risk and its required rate of
return.
This is a
model, which describes the relationship between risk and expected return. The expected return on a security, in the
risk-free rate plus a premium based on the systematic risk of the
security. A risk-free rate is the return
generated by government securities like treasury bills and treasury certificates
that are assumed to be guaranteed as such termed as risk-free securities. Thus, a risk-free security is the one that
has a zero standard deviation. Therefore,
the covariance between risk-free security and the risky security will be
zero. Even though there is complete
certainty of return on a risk-free security, the expected return is low
compared with other securities.
The Capital
Asset Pricing Model (CAPM) stresses that the expected risk premium on each
investment is proportional to its beta.
Beta is a measure of security’s risk relative to the market
portfolio. In the context of CAPM, the
risk of an individual security is defined as the volatility of the security’s
return vis-à-vis the return of a market portfolio. Beta is simply the gradient i.e., the change
in the excess return on the security over the change in excess return on the
market portfolio of a line that describes the relationship between an
individual security’s returns and returns on the market portfolio. Such a line is referred to as characteristic
line. When the gradient is 1.0, it means
that the excess returns for the security vary proportionately with excess for
the market portfolio. In other words,
the security has the same systematic risk as the market as a whole. A gradient less that 1.0 means that the
security’s excess returns varies less than proportionately with the excess return
of the market. This type of security is
often referred to as defensive investment.
If the gradient is steeper than 1.0, it means that the security’s return
varies more that proportionately with the excess return of the market
portfolio. In other words, it has more
undiversifiable risk than the market as a whole. And the beta of a portfolio is simply a
weighted average of the individual security betas in the portfolio. It should be noted that where beta of a security
is >1, it is called AGGRESSIVE STOCK,
which means that the price of the security rise and fall faster than the market. When beta of a security is <1, it is
called Defensive Stock, which means that the price of the security rise and
fall slower than the market. Beta is a
measure of non-diversifiable risk. Beta
shows how the price of the security responds to market forces. In other words,
beta of an asset is a measure of market sensitivity. In effect, the more responsive the price of a
security is to changes in the market, the higher will be its beta.
ASSUMPTIONS OF CAPITAL ASSET PRICING MODEL
(CAPM)
The Capital
Asset Pricing Model is developed on a number of assumptions. The following are the most important assumptions
(Pandey, 1999).
a.
Capital market efficiently, which implies that
security prices reflect all available information, no taxes, regulations or
floatation.
b.
Investor are risk-averters. When faced with a choice of the portfolio
having the same expected returns, they pick the portfolio with the lowest
standard deviation.
c.
Homogenous expectations, which imply that all
investors have the same expectations about the risk and expected return of
securities.
d.
Single time period, which means that all
investors’ decisions are based on single time period
e.
Risk-free rate, which means that all investors
can lend or borrow at a risk-free rate of interest.
f.
All investors analyze securities in the same way
and share the same economic view of the world.
Given the
above assumptions, according to CAPM, in equilibrium, the price of every
security in a way falls on the market line.
This means that each investment should lie on the sloping security
market line connecting treasury bills (The risk-free securities) and the market
portfolio. A security market line
describes the linear relationship between expected rates of return for
individual securities (and portfolios) and systematic risk, as measured by
beta. A security market line equation is given by:
E(Ri) = Rf
+[E(Rm)-Rf]Bi
E(Ri)=expected
return on security ‘I’
Rf = Risk-free rate
E(Rm) = expected return on a market portfolio
E (Rm) = beta
of security i.
 |
Βm=1
CAPITAL ASSET PRICING MODEL (CAPM).
The figure
illustrates the capital asset pricing model with the security market line (SML)
delineating the relationship between return for individual securities and
market risk as measured by beta. For a
given amount of market risk (β), SML shows the prevailing rate of return. A security’s beta of 1 indicates an average
level of systematic risk. If the
security’s beta is greater than 1, then it implies that the security’s returns
fluctuate more than the market returns. On
the other hand, a beta less than 1 means that the security’s returns are less
sensitive to the changes in the market returns.
In market
equilibrium, CAPM implies that the required rate of returns on a security
equals to its expected return, as such all securities will lie on the SML. Sometimes
however, securities may be underpriced or overpriced, as such not falling on
the SML like securities A and B in figure above. For instance, security A is
underpriced, i.e., E (RA) > RP + [E(RM)- RF]BA,
with this situation the security will be attractive to investors. Thus, the increased demand for the security
will cause the price to rise until it reaches the equilibrium situation of
equation (9-11). For security B, which is
overpriced, i.e., E(RB)<RF + [E(RM)]-RF]BB,
with this security will be unattractive to investors. Thus, the fall in demand for the security will
cause the price to decline until it reaches the equilibrium situation.
Hehehehe –
make una no fear oh. This is just
theory, as the practical will come ok.
You can’t predict Ndama. So you need some theory.
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