FINANCE SERIES-2

Prem Kumar

2nd year Student (finance)

IBS Hyderabad


Dear Friends!

We had discussed the Basics of Risk and Return in our last Paper.Having discussed the basics, we now come to some deeper concepts of CAPM.

CAPM (Capital Asset Pricing Model):

The CAPM is a model that relates Risk & Required Rate of Return (RRR) for assets in a well diversified portfolio.

Assumptions of CAPM:

• Single holding period
• Identical expectations for all investors
• Unlimited funds can be borrowed or lent at the risk free rate.
• Assets are perfectly divisible
• No taxes
• No transactions costs
• Price takers: Individual investor would not be able to influence market
• Fixed quantities of all assets

CAPM helps us to construct a portfolio of securities based on our specific Risk-Return Profile (What is your Risk – Return Profile?).We can make a variety of portfolios consisting of distinct weightage of stocks from a given set of stocks. All these portfolios make a feasible set of portfolio.

An Efficient portfolio is a portfolio of stocks chosen from the Feasible set of portfolios, which satisfies any one of these two conditions:

a)Maximum return for a given risk

b) Minimum risk for a given amount of return.

As can be understood with little mind boggling that within the frame of feasible set, one can have a collection of efficient portfolios. The collection of all these efficient portfolios is called the Efficient set /Efficient Frontier.

fig.1

Now, lets discuss one basic logic: If you are given a specific return A and are ready to face a risk X for expecting this risk. If there is an alternative return B for which you are ready to bear a risk Y and you have your own analysis of various such Risk –return tradeoffs ( Your Risk-Return Profile),then we take all such points on Risk-Return graph and connect them. This curve is your Indifference curve (Similar to one in Microeconomics).

An Indifference curve reflects an investor’s attitude towards risk/return trade off. Now your trade would definitely be different from mine. So all of us have our distinct Indifference curves based on our respective Risk averseness.

Now the point of intersection of your Indifference curve with efficient portfolio (efficient set) is called your optimal portfolio.

fig.2

Now, if we introduce an asset like Treasury bill (Risk free) in our so called optimum portfolio, what should happen?

We know, if Krf is the return of any such asset,then this will represent a point somewhere on Y axis( because risk representing X dimension is 0).This asset is included in our optimum portfolio,so this point should be added in new efficient frontier.

Hence draw a straight line from Krf , a tangent on old efficient frontier.

fig.3

The line MZ is called Capital Market Line and is defined as a locus of all possible combinations of Risk free asset and portfolio M.

Portfolios below CML are Inferior and all investors will choose a portfolio on CML.

fig.4

_{Now, what is your New optimum portfolio?}

Now, what is your New optimum portfolio?

It is the Point of intersection of Your Indifference Curve and CML.

Now let me make something clear because for beginners there is a very big confusion between two terms.

Capital Market Line (CML) is NOT Security Market Line (SML).

What is SML (Security Market Line)?

SML gives risk/return relationship for an individual stock whereas CML gives the same for efficient portfolios. We have already discussed SML in our last article.

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