CAPITAL ASSET

PRICING MODEL AND

MODERN PORTFOLIO
THEORY

CAPITAL ASSET PRICING MODEL (CAPM)

is a model based on the propositions that any stocks
required rate of return is equal to the risk-free rate of
return plus a risk premium that reflects only the risk
remaining after diversification.
it provides a general framework for analyzing riskreturn relationships for all types of assets.
do not use total risk in evaluating these relationship,
which is measured by standard deviation as a risk
measure, but only one part of total risk called
systematic risk.

TWO MAJOR COMPONENTS

Diversifiable Risk
Undiversifiable Risk

DIVERSIFIABLE RISK
also called unsystematic risk or company risk.
is that part of a securitys risk caused by factors unique to
a particular firm.
can be diversified away because it represents essentially
random events.
sources include lawsuits, strikes, company management,
marketing strategies and research and development
programs, operating and financial leverage., and other
events that are unique to the particular firm.

UNDIVERSIFIABLE RISK
also called systematic risk or market risk.
is that part of a securitys risk caused by factors
affecting the market as a whole.
cannot be eliminated by diversification because
it affects all firms simultaneously.
the only relevant risk and is affected by such
factor such as wars, inflation, interest rates,
business cycles, fiscal and monetary policies.

Figure 23-1. Effect of diversification on Unsystematic and

Systematic Risk

ILLUSTRATION
Case 23-1.
Suppose a particular stock has a risk-free rate of
5%, a rate of return on the market of 12% and a
beta (quantity of risk) of 1.5. What would be the
investors required rate of return?
Solution:
required rate of return = 5% + (12%- 5%) 1.5
= 15.5%

THE BETA COEFFICIENT CONCEPT

BETA
is a measure of the sensitivity of a securitys return relative
to the returns of a broad-based market portfolio securities. B
is defined mathematically as the ratio of the covariance of
returns security (i), and market portfolio (m), to the variance
of returns of the market portfolio.
measure the comovement between a stock and the market
portfolio. The tendency of a stock to move with the market is
reflected in its beta coefficient (b), which is a measure of the
stocks volatility relative to that of an average stock.

THE BETA COEFFICIENT CONCEPT

COVARIANCE
is an absolute statistical measure of the extent of
two variables, such as securities move together.
AVERAGE RISK
defined as one that tends to move up and down
in step with the general market as measured by
some index.

RELATIONSHIP BETWEEN RISK AND

RATE OF RETURN
The CAPM expresses risk-return relationship using beta as
the relevant risk measure. CAPM states that the required
rate of return on a risky asset consists of the risk-free rate
plus a premium for systematic risk.
CAPM Formula: ri = rf +bi (rmrf)
Where: ri = required (or expected) return on security, i
rf = expected risk-free rate of return
rm= expected return on the market portfolio
bi = beta coefficient of security, i

RELATIONSHIP BETWEEN RISK AND

RATE OF RETURN
1. Risk-free rate of return(rf) is the return required on a security
having no systematic risk and is generally measured by the
yield on short term Treasury securities such as treasury bills.
(a). The risk-free rate consists of two components: a real rate
that excludes
any inflationary expectations, and an
inflation premium that equals
the expected inflationary
rate.
(b). The risk-free rate changes in the same direction and by the
same
amount as the inflation premium changes.
Since the risk-free rate is
part of a securitys
required rate of return, a change in inflationary will

RELATIONSHIP BETWEEN RISK AND

RATE OF RETURN
2. Risk-premium, bi (rm- rf) is the return required in excess of
the risk-free rate and is due to systematic risk. Part of the risk
premium is the market risk premium (rm- rf), which is the
additional return expected for holding a market portfolio of
average riskiness (b = 1.0). The risk premium for a specific
security will differ from the market risk premium if the
individual securitys beta does not equal 1.0.