(Ch 13) CAPM model & correctly priced stocks - YouTube

"CAPM" model and correctly priced stocks.

First, what do we mean by "CAPM"?

It stands for "capital asset pricing model".

And the name implies that we are talking about the price for financial assets, such as stocks

and bonds.

The price for what?

The price for one share of stock, the price for one corporate bond, for any company.

Here's what we know: there's a company whose Beta is 1.5, and its expected return is 20%

per year.

Expected return on the market portfolio is 12%.

Treasury bill rate is 3%.

Are this company's stock shares priced correctly?

So, in this question we are talking about the price per share of stock reflecting a

combination of two things: risk and return.

So, the price should correctly reflect this sort of "high risk high return" "low risk

low return" relationship.

What do we mean by risk?

This is what Beta reflects.

The Beta is the amount of risk of stock returns.

Meaning, stock returns in real life fluctuate.

They go up and down, up and down.

Every year.

So there is this element of unpredictability, how much money you will earn every year in

the future.

Sometimes more, sometimes even more, sometimes less.

Right?

So, the Beta is a number around 1.

Maybe less than 1, maybe exactly 1, maybe above 1.

And it shows the following: relative to an average company's stock, how much do our company's

stock returns fluctuate from one year to the next when these fluctuations are caused by

very large scale events, the economy-wide events.

Like a recession, an expansion.

Something big happening.

Essentially something that we have no control over.

And so these fluctuations will happen no matter what you do as a smart investor, such as buying

a whole bunch of different companies' stocks so that losses may be offset by gains in your

portfolio.

With fluctuations caused by large-scale events you can not do anything about them, because

that's something that's happening across the board, across all stocks that you might have

in your portfolio.

And so, if the Beta is above 1, it means that company's stock is riskier than an average

stock.

Meaning, if something big happens in the economy, this company's stock is affected a lot more

than an average company's stock.

Okay.

So, we're talking about high risk, measured by Beta, which is also known as "systematic

risk", versus high return.

When something is risky you only wanna... you're only gonna wanna buy it if you're compensated

correctly for that amount of risk.

So, high risk high return.

And it's the part of stock return fluctuations, part of the total risk, that you have no control

over.

Which is also known as "systematic risk" or "non-diversifiable risk".

"Non-diversifiable risk".

And here we have expected return, which is "E" and brackets, "R".

So what is the relationship?

We have an average stock, which we call the "market portfolio", "M", which by definition

has the Beta of 1.

And it has some return.

It's actually given.

12%, right?

So we have 12% return.

That's given.

Then we have one more number.

3%.

3% is the Treasury bill rate which is also known as the risk-free rate.

Risk free.

"R" return, "f" stands for risk-free.

Okay.

And this is expected return on the market portfolio.

And these are the two points we need to draw what is known as the Security Market Line.

"SML".

So, it shows...

it slopes up and to the right, meaning there is a positive relationship between the amount

of systematic risk, that we have no control over, and the amount of return that investors

should expect when they buy shares of that company's stock.

So, any company would have a different combination of this risk and return, but all of them would

lie on this Security Market Line.

If they do, then whatever the price per share is, that's the correct price per share.

So, all stocks lying on this line are priced correctly.

Now, let's look at our company.

What do we have?

We have 1.5 for our Beta.

Let's see what the correct rate of return should be.

So, expected return on our company's stock shares should equal... the CAPM formula says:

take the risk-free rate, plus Beta for that company multiplied by the expected return

on the market portfolio minus the risk-free rate.

So, if you plug in the numbers: we have 3%, risk-free rate, plus the Beta 1.5 for our

stock, multiplied by 12% return on the market minus 3% again for the Treasury bills.

And if you do the math you should get 0.165, or 16.5%.

So, let's label it here.

So this here is 16.5%.

Okay.

So, what's happening here?

Do we have 16% per year given?

No!

We have more than that.

We actually have 20% return.

Our stock on this graph lies above the Security Market Line, which tells us that the shares

of this company's stock are not priced correctly.

They are mispriced.

They are not what they should be.

So what can we say about this company's stock?

If the return is so high, all investors would have a high interest in buying this company's

stock shares, right?

So, the demand would grow, the price per share would be driven up, and that would kill any

return that you would be earning in the next year.

So if you buy for a lot of money that would kill your potential profit you could make,

right?

So it means that the return will eventually, over some amount of time, start going down.

And it will stop when we reach the Security Market Line.

So as the price grows, the return falls, and eventually the price will be high enough,

just right.

In other words, this company's stock shares are not priced correctly.

They are underpriced!

Underpriced.

Right?

In other words, shares are too cheap!

Right?

So, in a way things are kind of seem backwards graphically.

Over the line - underpriced.

A reverse situation would be if the information that we are given implied that we have a point

somewhere under the Security Market Line.

Under the line would imply the opposite situation: shares of stock are way too expensive.