CAPM

Modern Portfolio theory

MPT was developed by Harry Markowitz and published under the title "Portfolio Selection" in the 1952 Journal of Finance.

MPT says that it is not enough to look at the expected risk and return of one particular stock. By investing in more than one stock, an investor can reap the benefits of diversification -

• Modern portfolio theory states that the risk for individual stock returns has two components:

Systematic Risk - These are market risks that cannot be diversified away. Interest rates, recessions and wars are examples of systematic risks.

Unsystematic Risk - Also known as "specific risk", this risk is specific to individual stocks and can be diversified away as you increase the number of stocks in your portfolio ..

For a well-diversified portfolio, the risk - or average deviation from the mean - of each stock contributes little to portfolio risk. Instead, it is the difference between individual stocks' levels of risk that determines overall portfolio risk. As a result, investors benefit from holding diversified portfolios instead of individual stocks.

For every level of return, there is one portfolio that offers the lowest possible risk, and for every level of risk, there is a portfolio that offers the highest return. These combinations can be plotted on a graph, and the resulting line is the efficient frontier

Any portfolio that lies on the upper part of the curve is efficient: it gives the maximum expected return for a given level of risk. A rational investor will only ever hold a portfolio that lies somewhere on the efficient frontier. The maximum level of risk that the investor will take on determines the position of the portfolio on the line.

Efficient Frontier

Construct a risk/return plot of all possible portfolios– Those portfolios that are not

dominated constitute the efficient frontier

Capital market line

Standard Deviation

Expected Return (%)

•Lending or Borrowing at the risk free rate (rf) allows us to exist outside the

efficient frontier.

rf

Lending

BorrowingT

S

Capital market line

When the market portfolio is combined with the risk-free asset, the result is the Capital Market Line. All points along the CML have superior risk-return profiles to any portfolio on the efficient frontier.

The CML is considered to be superior to the efficient frontier since it takes into account the inclusion of a risk-free asset in the portfolio.

What is Beta?

The degree to which different portfolios are affected by these systematic risks as compared to the effect on the market as a whole, is different and is measured by Beta. To put it differently, the systematic risks of various securities differ due to their relationships with the market. The Beta factor describes the movement in a stock's or a portfolio's returns in relation to that of the market returns. For all practical purposes, the market returns are measured by the returns on the index (Nifty, Mid-cap etc.), since the index is a good reflector of the market.

CAPMA model that describes the relationship

between risk and expected return and that is used in the pricing of risky securities.

It says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium.

If this expected return does not meet or beat the required return, then the investment should not be undertaken.

The security market line plots the results of the CAPM for all different risks (betas).

Security Market LineReturn

.

rf

Risk Free

Return =

Efficient Portfolio

Market Return = rm

BETA1.0

Capital Asset Pricing Model

R = rf + B ( rm - rf )

CAPM