CAPM - CAPITAL ASSET PRICING MODEL

Derivative Markets
Dividend Discount Model (DDM&DCF)
Investment Criteria
Valuation of Bonds and Stocks
Value Concepts
CAPM - CAPITAL ASSET PRICING MODEL
* CAPM stands for Capital Asset Pricing Model. It is a financial model that
helps investors to determine the expected return on an investment based
on its risk.
* According to the CAPM, the expected return of an investment is equal to
the risk-free rate plus a premium that reflects the investment's systematic
risk (also known as beta).
Assumptions
 Market is efficient
 There is no tax and transaction cost
 At all time market has a risk free return benchmark
 Risk is measured on the basis of standard deviation
 Investor desire is maximum return at minimal risk
The CAPM formula is :
Expected return = Risk-free rate + Beta x (Market risk premium)
Expected return = Rf + ẞ(Rm - Rf)
* The risk-free rate is the theoretical rate of return of an investment that
has zero risk, such as a U.S. Treasury bond.
* The market risk premium is the additional return an investor can expect
to earn above the risk-free rate for taking on the risk of investing in the
stock market.
* Beta measures the volatility of an investment relative to the overall
market. A beta of 1.0 indicates that the investment's price moves in line
with the market, while a beta of less than 1.0 indicates that the investment
is less volatile than the market, and a beta of greater than 1.0 indicates
that the investment is more volatile than the market.
* Investors use the CAPM to evaluate the expected return of a given
investment compared to its required rate of return, and to determine
whether the investment is undervalued or overvalued.
CAPM and Beta* The beta of a potential investment is a measure of how
much risk the investment will add to a portfolio that looks like the market.
If a stock is riskier than the market, it will have a beta greater than one. If a
stock has a beta of less than one, the formula assumes it will reduce the
risk of a portfolio.
* A stock's beta is then multiplied by the market risk premium, which is
the return expected from the market above the risk-free rate. The risk-free
rate is then added to the product of the stock's beta and the market risk
premium. The result should give an investor the required return or
discount rate that they can use to find the value of an asset.
The CAPM is based on a number of assumptions, including:
* Investors are rational and risk-averse: Investors are assumed to make
rational decisions based on their own risk preferences and are risk-averse,
meaning that they require compensation for taking on additional risk.
* Perfect capital markets: The CAPM assumes that capital markets are
perfect, meaning that investors can borrow and lend money at the same
risk-free rate, and that there are no transaction costs, taxes or other
market imperfections.
* Homogeneous expectations: All investors have the same
expectations about the future returns of investments and the future risk of
the market.
* The market portfolio is efficient: The market portfolio is assumed to be
the most efficient portfolio, meaning that it offers the highest expected
return for a given level of risk.
* The CAPM has been criticized for its reliance on these assumptions,
which are not always realistic. Critics argue that the model may not
accurately reflect the complexity of real-world markets, and that it may be
too simplistic to fully capture the risks and returns of investments.
* Despite these criticisms, the CAPM remains an important tool for
investors and is widely used in finance to estimate the expected return of
investments and to determine the cost of capital for businesses.
* The Capital Asset Pricing Model is a mathematically simple estimate of
the cost of equity. The rate of return required is based on the level of risk
associated with the investment. CAPM states that investors require
additional returns (risk premium) in excess of a risk-free rate proportional
to market risk.
Advantages and Disadvantages of CAPM
Advantages of CAPM:
* Simple and Easy to Use: The CAPM model is straightforward and easy to
use, making it a popular method for calculating the expected return on
investments.
Separates Systematic and Unsystematic Risk: The model helps investors to
separate the systematic risk of an investment from its unsystematic risk,
allowing for a more accurate estimate of the risk and return of an
investment.
* Widely Used: The CAPM is widely used in the finance industry, and is an
important part of many investment strategies and financial analyses.
* Helps Determine the Cost of Capital: The CAPM helps businesses to
determine their cost of capital, which is important for making investment
decisions and assessing the financial viability of projects.
Disadvantages of CAPM:
* Relies on Assumptions: The CAPM relies on a number of assumptions,
such as perfect capital markets and homogeneous expectations, which
may not be accurate in real-world situations.
* Ignores Non-Market Risk: The model only takes into account the market
risk of an investment, and does not consider non-market risks such as
political risk, liquidity risk, or credit risk.
* Historical Data: The CAPM relies on historical data to estimate the
market risk premium and beta, which may not accurately reflect the future
risk and return of an investment.
* Limited Applicability: The CAPM may not be applicable to all types of
investments or to all market conditions, and may not provide accurate
estimates of the expected return for certain investments or in certain
situations
Derivative Markets

The word Derivative is derived from mathematics which refers to a

variable that has been derived from another variable. In simple sense,
Derivative has no independent value of its own; its value is obtained
from the value of an underlying asset. In financial world, a derivative is
a financial product which derives its value from another asset.
Features of Derivatives 1. Derivatives are the part of secondary
market and no funds can be raised through derivatives. 2.The
transactions in the Derivative are settled by taking offsetting position
in the same derivatives. 3. No limit on the number of units transacted
because there is no physical asset involved. 4. Derivative market is
quite liquid in nature. 5. These are tailor made instruments and its use
depends upon investors requirement.

Two Purposes of Derivatives Price Discovery of the underlying asset:

Prices in an organized derivative market reflect the perception of
market participants about the future and lead the prices of underlying
to the perceived future level. Price of derivative coincides with price of
underlying at the expiration date. Thus, it helps in price discovery.
 Tool for Risk management: Derivative instruments helps in transfer
risks through hedging from the hedger to the speculator. Derivative
Types Options: Options are financial derivative contracts that give
the buyer the right, but not the obligation, to buy or sell an underlying
asset at a specific price (referred to as the strike price) during a
specific period of time. American options can be exercised at any time
before the expiry of its option period. On the other hand, European
options can only be exercised on its expiration date.
 A forward contract: is a non-standardized contract between two
parties to buy or sell an asset at a specified future time, at a price
agreed upon today. The party agreeing to buy the underlying asset in
the future assumes a long position, and the party agreeing to sell the
asset in the future assumes a short position. The price agreed upon is
called the delivery price, which is equal to the forward price at the
time the contract is entered into. The forward price of such a contract
is commonly contrasted with the spot price, which is the price at
which the asset changes hands on the spot date. The difference
between the spot and the forward price is the forward premium or
forward discount, generally considered in the form of a profit, or loss,
by the purchasing party.  A futures contractdiffers: from a forward
contract in that the futures contract is a standardized contract written
by a clearing house that operates an exchange where the contract can
be bought and sold. On the other hand, the forward contract is a non-
standardized contract written by the parties themselves. Forwards
also typically have no interim partial settlements– or “true-ups”– in
margin requirements like futures, such that the parties do not
exchange additional property, securing the party at gain, and the
entire unrealized gain or loss builds up while the contract is open.

Swaps: are derivatives in which counterparties exchange cash flows

of one party’s financial instrument for those of the other party’s
financial instrument. For example, in the case of a swap involving two
bonds, the benefits in question can be the periodic interest (or
coupon) payments associated with the bonds. Specifically, the two
counterparties agree to exchange one stream of cash flows against
another stream. The swap agreement defines the dates when the cash
flows are to be paid and the way they are calculated. Usually at the
time when the contract is initiated at least one of these series of cash
flows is determined by a random or uncertain variable such as an
interest rate, foreign exchange rate, equity price or commodity price
1. Dividend Discount Model (DDM) The dividend discount model is
one of the basic techniques of absolute stock valuation. The DDM is
based on the assumption that the company’s dividends represent the
company’s cash flow to its shareholders. Essentially, the model states
that the intrinsic value of the company’s stock price equals the
present value of the company’s future dividends. Note that the
dividend discount model is applicable only if a company distributes
dividends regularly and the distribution is stable.
2. Discounted Cash Flow Model (DCF) The discounted cash flow
model is another popular method of absolute stock valuation. Under
the DCF approach, the intrinsic value of a stock is calculated by
discounting the company’s free cash flows to its present value. The
main advantage of the DCF model is that it does not require any
assumptions regarding the distribution of dividends. Thus, it is suitable
for companies with unknown or unpredictable dividend distribution.
However, the DCF model is sophisticated from a technical perspective
3. Comparable Companies Analysis The comparable analysis is an
example of relative stock valuation. Instead of determining the
intrinsic value of a stock using company’s fundamentals, the
comparable approach aims to derive a stock’s theoretical price using
the price multiples of similar companies. The most commonly used
multiples include the price to-earnings (P/E), price-to-book (P/B), and
enterprise value-to EBITDA (EV/EBITDA). The comparable companies
analysis method is one of the simplest from a technical perspective.
However, the most challenging part is the determination of truly
comparable companies
Investment Criteria implies the appraisal of various investment
projects in view of their utility and cost of production. Quite often a
business organisation has to face the problem of large investment
decision or capital expenditureThe process of making investment
decisions in capital expenditures is known as capital expenditure
management
1. Net Present Value Method The net present value method is one of
the discounted cash flow or time adjusted method. This is generally
considered as the best method for evaluating capital investment
proposals. This method takes into consideration the time value of
money and attempts to calculate the return on investments by
introducing the factor of ‘time element’
It recognises the fact that a Rupee earned today is worth more than
the same Rupee earned tomorrow. In this method, an appropriate
rate of interest should be selected as the minimum rate of return and
present value of total investment outlay is calculated
PV = 𝟏/ (𝟏+𝐫n)
2. Benefit Cost Ratio This method is based on time adjusted
techniques and also called benefit cost ratio It is used as an indicator
that attempts to summarise the overall value of money of an
investment project or proposal. A BCR is the ratio of the benefits of a
project or proposal, expressed in monetary terms, relative to its
costs, also expressed in monetary terms
BCR or Profitability Index = 𝐞𝐬𝐞𝐧𝐭 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰𝐬
𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐜𝐚𝐬𝐡 𝐨𝐮𝐭𝐟𝐥𝐨𝐰s
3. Internal Rate of Return Method The net present value method
does not provide a good measure for investment decisions when
there are more than one projects with different cash flows. Internal
rate of return (IRR) takes into account the time value of money. It is
also known as “time adjusted rate of return IRR is a method of
calculating an investment’s rate of return
Internal rate of return can be defined as that rate of discount at
which the present value of cash flows is equal to the present value of
cash outflows
That is, C ( ) ( )
Where C= initial outlay.
This method measures the rate of return which earnings are
expected to yield on investments

4. Modified Internal Rate of Return Method

The modified internal rate of return (MIRR) is a financial measure of
an investment's attractiveness. It is used to rank alternative
investments of equal size. As the name implies, MIRR is a
modification of the internal rate of return (IRR) and as such aims to
resolve some problems with the IRR
MIRR resolves two of problems of IRR. Firstly, IRR is sometimes
misapplied, under an assumption that interim positive cash flows are
reinvested elsewhere in a different project at the same rate of return
offered by the project that generated them. This is usually an
unrealistic scenario and a more likely situation is that the funds will
be reinvested at a rate closer to the firm's cost of capital. The IRR
therefore often gives an unduly optimistic picture of the projects
under study. Generally, for comparing projects more fairly, the
weighted average cost of capital should be used for reinvesting the
interim cash flows. Secondly, more than one IRR can be found for
projects with alternating positive and negative cash flows, which
leads to confusion and ambiguity. MIRR finds only one value.

M𝐈𝐑𝐑 = √ ( ) −𝟏
𝐏𝐕 (𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐨𝐮𝐭𝐥𝐚𝐲𝐬 × 𝐟𝐢𝐧𝐚𝐧𝐜𝐢𝐧𝐠 𝐜𝐨𝐬𝐭𝐬)
The MIRR is used to rank investments or projects of unequal size.
Valuation of Bonds and Stocks
A bond is a debt instrument that provides a steady income stream to
the investor in the form of coupon payments. At the maturity date,
the full face value of the bond is repaid to the bondholder. The
characteristics of a regular bond include: • Coupon rate: Some bonds
have an interest rate, also known as the coupon rate, which is paid to
bondholders semi-annually. The coupon rate is the fixed return that
an investor earns periodically until it matures. • Maturity date: All
bonds have maturity dates, some short term, others long-term. When
a bond matures, the bond issuer repays the investor the full face value
of the bond. For corporate bonds, the face value of a bond is usually
$1,000 and for government bonds, the face value is $10,000. The face
value is not necessarily the invested principal or purchase price of the
bond. • Current price: Depending on the level of interest rate in the
environment, the investor may purchase a bond at par, below par, or
above par. For example, if interest rates increase, the value of a bond
will decrease since the coupon rate will be lower than the interest rate
in the economy. When this occurs, the bond will trade at a discount,
that is, below par. However, the bondholder will be paid the full face
value of the bondat maturity even though he purchased it for less
than the par value takes into account the price of a bond, par value,
coupon. Bond valuation includes calculating the present value of a
bond's future interest payments, also known as its cash flow, and the
bond's value upon maturity, also known as its face value or par value.
Because a bond's par value and interest payments are fixed, an
investor uses bond valuation to determine what rate of return is
required for a bond investment to be worthwhile.
• Zero-Coupon Bond Valuation A zero-coupon bond makes no annual
or semi-annual coupon payments for the duration of the bond.
Instead, it is sold at a deep discount to par when issued. The
difference between the purchase price and par value is the investor’s
interest earned on the bond. To calculate the value of a zero-coupon
bond, we only need to find the present value of the face value. Under
both calculations, a coupon-paying bond is more valuable than a zero-
coupon bond. • Convertible Bonds Valuation A convertible bond is a
debt instrument that has an embedded option that allows investors to
convert the bonds into shares of the company's common stock.
Convertible bond valuations take a multitude of factors into account,
including the variance in underlying stock price, the conversion ratio,
and interest rates that could affect the stocks that such bonds might
eventually become. At its most basic, the convertible is priced as the
sum of the straight bond and the value of the embedded option to
convert
Value Concepts
Book Value: The book value of an asset or a firm is based on
accounting reports. In case of a physical asset, it is equal to the asset's
historical cost less accumulated depreciation. In case of a common
stock, it is equal to the net worth (paid-up capital + reserves and
surplus) of the firm divided by the number of outstanding shares.
Symbolically, Going-Concern Value: This concept applies to a business
firm as a continuing operating unit. It is based primarily on how
profitable a firm's operations would be as a continuing entity that is,
the entity which is unlikely to go out of business in the foreseeable
future. Liquidation Value: In contrast to the going-concern value, the
liquidation value is the value of the business firm which has cease or
wound up its business, or which has gone into liquidation. The
liquidation value of an ordinary share is equal to the value realised
from liquidating all the assets of the firm minus the amount to be paid
to all the creditors, preference shareholders, and other prior claimants
divided by the number of outstanding ordinary shares. Market Value:
The market value of an asset is simply the price at which it is traded in
the market at a given point of time. Intrinsic or Present Value:
Intrinsic value is also known as fair market value or investment value.
It is equal to the present value of a stream of cash flows expected to
be generated by the asset. The technique for finding out present value
is known as discounting. Market value truly reflects intrinsic value if
the market is perfectly competitive. Terminal Value: The terminal
value of the asset or money is the value of today's money at some
point of time in future, and the method for ascertaining it is known as
compounding. Time Value of Money It connotes that a rupee today in
hand is worth more than a rupee tomorrow because it can be invested
and made to earn interest immediately, and because the present
consumption is valued more than the future consume the people