LECTURER NOTE : CAPITAL ASSET PRICING MODEL

CAPM...one of the popular investment theory to compute the rate of return (Required Rate of Return, but sometimes also refer to Expected Rate of Return).  Hence, the minimum requirement to invest is when RRR=ERR or ERR=RRR.

CAPM derived from  RRR=RFR + (RM-RFR)Beta i
             where:  RRR = Required Rate of Return
                         RFR = Risk Free Rate ...e.g instrument like Treasury Bill
                         RM  = Market Risk or Market Return
                                 (RM-RFR) = Risk Premium
                         Beta i = degree of tendency in risk or return of asset i as compared to the market

Assume, Stock CMC has beta 0.5, risk free rate is 10%, the market risk 12%, so the required rate of return for Stock CMC = 10% + (12% - 10%)0.5 =11%.
Let say, if the Expected Return for CMC is 8%, the investor should not buy the stock since it is over-valued.

As a conclution, the CAPM is designed to help investor to derive their required rate of return before make any investment decisions.  Always remember that, the best situation to invest is when ERR is bigger than RRR or at least ERR equal to RRR.

Key Words:      ERR > RRR            Under-value        GOOD
                         ERR = RRR           Fair-value             GOOD
                         ERR < RRR           Over-value           NOT GOOD

The same CAPM theory also apply to portfolio, in this case the formula is;

RRRp = RFR + (RM - RFR) Beta  portfolio
where;   Beta portfolio = sum of Wi X Bi     ; Wi = weighted allocation for asset i,  Bi = Beta asset i.

Assume that, you have a portfolio consist of two assets, Stock A and Stock B, the information shown bellow.
                                     Weighted       Beta asset
       Stock A                    0.3                               1
       Stock B                    0.7                           0.5 
Therefor, Beta portfolio = (0.3)(1) + (0.7)(0.5) = 0.65
if, risk free rate is 12% and market risk at 16%, the RRR for your portfolio will be 14.6%.

                [RRRp = 12% + (16% -12%)0.65 = 14.6%]



EXERCISE;
1. Find RRR and make the decision for Stock A, Stock B, Stock C and Sock D based on the information given 
    bellow.
                            ASSET                          BETA             ERR
                          Stock A                           0.5                  10%
                          Stock B                           0.7                  12%
                          Stock C                           1.2                  20%
                          Stock D                           1.0                  15%
  the required rate of return is 10% and market risk is 14%.

2. Now you are about to form a portfolio based on information in question 1.  The weighted ratio for each asset is 0.2:0.2:0.4 and 0.2. Find the RRRportfolio.

End of lesson...TQVM see ya again.