Page 86 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes The CAPM can be divided into two parts (1) risk-free interest Rf which is required return on a
risk free asset typically treasury bill or short-term government security and (2) the risk premium.
These are respectively the two elements on the either side of the plus sign in the above equation.
The (km – Rf) portion of the risk premium is called the market risk premium, because it represents
the premium – the investor must receive for taking the average amount of risk associated with
holding the market portfolio of assets.
The risk premium is the highest for small company stocks, followed by large company stocks,
long-term corporate bonds, and long-term government bonds. Small company stocks are riskier
than large company stocks, which are riskier than long-term corporate bonds (equity is riskier
than debt instrument).
Long-term corporate bonds are riskier than long-term government bonds (because the
government is less likely to ravage on debt). And of course, treasury bills and short-term
government securities because of no default risk, very short maturity virtually risk-free as
indicated by zero risk premium.
Other things being equal, the higher the beta, the higher the required return and lower the beta,
the lower the required return.

Example: B Co. Ltd., wishes to determine the required rate of return on an asset Z, which
has a beta of 1.5. The risk free rate of return is 7%, the return on market portfolio of assets is 11%.
Thus we get:
Kz = 7% + 1.5 (11% –7%) = 7% + 6% = 13%

The market risk premium 4% (11% –7%) when adjusted for the assets index of risk (beta) of 1.5,
results in a risk premium of 6% (1.5 × 4%). That risk premium when added to 7% risk-free return,
results in 13% required return.
5.5.1 Assumptions of CAPM

1. Market efficiency: The capital markets are efficient. The capital market efficiency implies
that share prices reflect all available information.

2. Risk aversion: Investors are risk-averse. They evaluate a security’s return and risk in
terms of the expected return and variance or standard deviation respectively. They prefer
the highest expected return for a given level of risk.
3. Homogenous expectations: All the investors have the same explanation about the expected
return and risk of securities.
4. Single time period: All investors can lend or borrow at risk-free rate of interest.
5. Risk-free rate: All investors can lend or borrow at a risk-free rate of interest.

5.5.2 Interpreting Beta
The beta of a portfolio can be easily estimated by using the betas of the individual assets it
includes. Suppose w , represent the proportion of the portfolio’s total rupee value represented
1
by asset j, and let , denotes beta of the asset, the portfolio beta
n
(
=
p = (w ×  ) + (w ×  ) + ………….. wn ´  ) å w ´
1 1 2 2 n 1 1
i 1
=
n
of course å = I which means that 100 per cent of the portfolio’s assets must be
=
i 1
included in the computation.
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