3. CAPM

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Do curso por Indian School of Business

Trading Basics

312 ratings

Indian School of Business

Trading Basics

312 ratings

Curso 1 de 5 em Specialization Trading Strategies in Emerging Markets

The purpose of this course is to equip you with the knowledge required to comprehend the financial statements of a company and understand the various transactions that take place in the stock market so that you can replicate the strategies discovered by the extant academic literature. The first part of the course provides a brief introduction to financial statements and various common filings of firms. You will learn how to obtain information regarding a company's performance from them and use the information to build trading strategies. Next, you are taught basic asset pricing theories so that you will be able to calculate the expected returns of a stock or a portfolio. Finally, you will be introduced to the actual functioning of asset markets, type of players in the market, different types of orders and the efficient ways and opportune time to execute them, trading costs and ways of minimizing them, the concept of liquidity .etc. This knowledge is required to develop efficient algorithm to execute various trading strategies.

Na lição

Asset pricing theories

Before you start trading, you should first be able to calculate the expected return from a stock. The expected return comes from various asset pricing models such as Capital Asset Pricing Model (CAPM), Arbitrage Pricing Theory (APT) and Fama-French Three Factor Model. The purpose of this module is to equip you with the skills required to calculate the expected returns of a stock (or) a portfolio. After completing this module you will be able to calculate the expected returns of a stock.

1. Expected returns and risk6:27

2. Diversification5:58

4. CAPM Beta6:10

5. Multifactor Models5:55

7. Arbitrage6:32

8. Arbitrage-Free Price6:03

9. Risk Factors4:44

Conheça os instrutores

Ramabhadran Thirumalai
Assistant Professor
Indian School of Business

Learning outcomes.

After watching this video you will be able to

write the capital asset pricing model CAPM.

Explain market risk premium.

Discuss what type of risk beta measures.

The CAPM.

Last time we saw the preliminaries necessary to understand the CAPM better.

In this video, we will see the mathematical form of the CAPM.

The CAPM is written as follows.

The expected return of any risky asset i equals the risk-free rate of return

plus the beta of the risky asset i times the difference

between the expected return on the market portfolio and the risk-free rate.

In notations, the expected return of the risky asset is denoted by E(r sub i).

The risk-free rate of return is denoted by r sub f.

The beta of the risky asset is denoted by beta sub i and

the expected return of the market portfolio is denoted by E(r sub m).

We defined the market portfolio last time.

Beta is the measure of risk in the CAPM.

Later we will discuss what type of risk it measures.

In plain English, the CAPM says that the expected return

of any risky asset over and above the risk free rate of return,

equals the sensitivity of its return with respect to the market portfolio,

which is denoted by beta times the expected market risk premium.

The expected market risk premium is the difference between the expected

return on the market portfolio and the risk-free rate of return.

It tells us how much return in excess of the risk-free rate of return

an investor expects to earn from holding the market portfolio.

In other words, what is an investor's compensation for

holding the risk of the market portfolio.

So what does beta measure?

We talked about diversifiable idiosyncratic risk and

non-diversifiable systematic risk.

The market portfolio is mean-variance efficient.

This says that idiosyncratic risk,

to the extent possible, has been diversified away.

So whatever risk remains in the market portfolio is systematic risk.

This means that beta is a measure of systematic risk.

The more important implication is that investors expect to be compensated

only for holding non-diversifiable systematic risk and not for

holding diversifiable idiosyncratic risk.

Investors are expected to be smart enough to diversify away

idiosyncratic risk by forming portfolios.

How do we calculate an asset's beta?

Beta sub i equals the covariance between the risky asset's returns and

the market portfolio's returns divided by the variance

of the market portfolio's returns.

The covariance is denoted by Cov(r sub i, r sub m) and

the variance of the market portfolio's returns is denoted by sigma m squared.

What can we say about the beta of the market portfolio?

If we use the formula we will have the covariance between the market's returns

and the market's returns, which is simply the variance of the market's returns

divided by the variance of the market's returns.

Thus, the beta of the market portfolio is 1.

An asset that has a beta greater than 1 is riskier than the market portfolio,

while that with a beta less than 1 is less riskier than the market portfolio.

The risk-free asset, by definition, has no risk and so its beta is 0.

Can beta be less than 0?

What does it mean to have a negative beta?

The answer is yes, beta can be negative.

This means that the asset's return will move in a direction

opposite to that of the market's returns.

If the market return is positive,

the asset with a negative beta will have a negative return and vice versa.

Next time, we will use a formula for beta to calculate the beta of a risky asset.

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