Wednesday, January 14, 2009


The Capital Asset Pricing Model.(CAPM).

1. Introduction.
The relevant risk of a security is not its total risk but the impact it has on the risk of the portfolio to which it is added. CAPM simply allows us to split the total risk of a security into the proportion that may be diversified away, and the proportion that will remain after the diversification process. This remaining risk is the relevant risk for appraising investments.

2. systematic and non-systematic risks.
Initially substantial reductions in total risk are possible: however, as the portfolio becomes more and more diversified, risk reduction slows down and eventually stops.
The risk that can be eliminated by diversification is referred to as non-systematic or unique risk. This risk is related to factors that affect the returns of individual investments in unique ways (eg. The risk that a particular firm’s labour force might go on strike.)
The risk that cannot be eliminated by diversification is referred to as non-systematic or unique risk. To some extent the fortunes of all companies move together with the economy. Changes in macro economic variables such as interest rates exchange rates, taxation, inflation, etc, affect all companies to a grater or lesser extent and cannot be avoided by diversification. That is, they apply systematically right across the market.
The relevant risk of an individual security is its systematic risk and it is on this basis that we should judge investments. Non-systematic risk can be eliminated and is of no consequence to the well diversified investor. Note that it is not necessary- to hold the market portfolio to diversify away non-systematic risk-a portfolio of 15-20 randomly selected securities will eliminate the vast majority of it.

3. systematic risk and return .As non-systematic risk can be diversified away, investors need only concern themselves with (and will only earn returns, for taking) systematic risk. The nest problem is how to measure the systematic risk of investments.
The method adopted by CAMP to measure systematic risk is an index, normally referred to as beta (B ). As with any index we need to establish some base points and then other observations will be calibrated around these points. The two base points are as follows.
a) The risk-free securityThis carries no risk and therefore no systematic risk. The risk-free security hence has a beta of zero.b) The market portfolioThis represents the ultimate in diversification and therefore contains only systematic risk.
We will set beta to 1. 00 for the market portfolio and this will represent the average systematic risk for the market.

4. Establishing beta factors for individual securities.
In theory we need to determine future B factors for the individual company (in order to appraise future investments). In practical terms we will content ourselves with establishing past B s and use these to appraise required returns on fresh investment projects, assuming such fresh projects do not affect overall company risk as viewed by investors.

a) It can be seen that small changes in market returns in the past have been accompanied by much larger changes in the return on this particular security. From this we can infer that security carries more systematic risk than the market portfolio.
b) The exact amount of systematic risk can be determined by establishing the slope of the line of best fit (the security characteristic line). The slope of the line in fact equals the security’s B factor. In this case the line is very steep and its slope (and therefore its B factor) will be greater than. 1 .00. This confirms our observation in (a).
c) The spread of observations around the line is of no great concern to us. This generally represents the non-systematic risk and will be diversified away by well- diversified investors.

5. regression analysis.
regression analysis rather than graphs is normally used to measure B s. the slope of a line in regression analysis can be expressed in several ways, but from our point of view the easiest is probably.
6. aggressive and defensive shares.The expected return on the market portfolio will change in relation to changed economic exceptions this, in turn, will cause a change in the expected return of shares which depends on their beta factors.

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