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Description

Corporate and International Finance

Assignment No

(BY CAPM AND BETA VALUE)

SUBMITTED BY:

ANOOP SAXENA

Page 1 of 25

K0226432

SUBMITTED TO:

Dr Yongsheng Guo

Contents Introduction Companies’ profile

• Tesco profile • Royal Bank of Scotland What is Beta

? Calculation of beta for Tesco Calculation of beta for Royal Bank of Scotland Required rate of return Calculation of expected rate of return Significance and assumption of CAPM Acceptability or Implication of CAPM Page 2 of 25

Conclusion Reference Bibliography Appendix

Introduction In the mid-1960s,

the three economists- William Sharpe,

John Lintner,

found the simple equation to calculate the risk and expected return on the investment of capital

This model or equation is known as the Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM) is the model used to describe the relation between the risk and expected return on the investment

It helps the investors to determine the appropriate price of the investment Ri=Rf+βRm-Rf

Ri = rate of expected return Rf = risk free return (treasury bills,

libor rate) Rm =rate of market return  = beta value of company

Page 3 of 25

CAPM is a simple but powerful model

Moreover it takes into the basic principles of portfolio selections:

• Efficient portfolios (Maximize excepted return subject to risk)

• The highest risk premium to standard deviation is a combination of the market portfolio and the riskfree asset

• Individual stocks should be selected on their contribution to portfolio risk

• Beta measures the marginal contribution of the stock to the market portfolio

Page 4 of 25

Companies’ profile Tesco profile Tesco is one of the major grocery retail company

With its subsidiaries,

The Tesco is the thirdlargest retailer in the world measured in terms of revenue,

And second largest in terms of profit after Wal-mart

There are more than 4811 stores across the globe( United Kingdom,

Hungary,

Poland,

Slovakia,

Turkey,

Thailand,

South Korea,

Malaysia,

The company was founded by Jack Cohen in 1919

And opens its first store in 1929 in Burnt Oak,

Edgware,

Middlesex

The store operates over 40,000 product line

The store operates in multi-store formats across the United Kingdom

The stores sales all kinds of products that includes food,

pharmaceutical products and clothing’s and others products

Royal Bank of Scotland The Royal Bank of Scotland Group plc,

offers banking and financial services to Page 5 of 25

and institutional customers in the United Kingdom,

Royal Bank of Scotland has around 700 branches,

mainly in Scotland though there are branches in many larger towns and cities throughout England and Wales

It provides private banking and investment services,

and debt and equity financing and risk management services,

credit markets and portfolio management and origination services

The company also offers global payments,

cash and liquidity management,

and trade finance and commercial card products and services

sells and underwrites retail and SME insurance over the telephone and Internet,

as well as through brokers and partnerships

including motor insurance under the brands of Direct Line,

Churchill,

Privilege,

Green Flag,

In addition,

it provides operational technology,

customer support in telephony,

lending and money transmission,

The company was founded in 1727 and is headquartered in Edinburgh,

The Royal Bank of Scotland Group plc operates as a subsidiary of HM Treasury

What is Beta

“The market risk is measured by Beta

it shows the sensitivity of the return is to the market movements

Beta measures the risk of an asset relative to the average asset

By definition the average assets have the beta value 1,

” Beta can be defined as – “a quantitative measure of the volatility of a given stock,

relative to the overall market

Specifically,

or portfolio has experienced in the last 5 years as the market moved 1% up or down

A beta above 1 is more volatile than the beta whose value is less than 1

”( investorwords) Beta value of a stock can take one of the following forms

Negative Beta – This is a rarity,

and means the stock is moving just reverse to the market

Zero (0) Beta – This means the value of the stock stays same irrespective of market movement

Again a rarity

Beta between 0 and 1 – This means the stock price swing less compared to market movements

Many blue chip company stocks and high-liquidity stocks have beta less than one

In a long-term prospective these stocks fall under low-risk lowprofit category

Beta of 1 – This means the stock price moves in the same relation with the market

This can be the case with many index-related products

Beta greater than 1 – This means the stock price swings more compared to market movements

Page 7 of 25

Many growing companies and technology companies have beta greater than one

Most of these stocks fall under high-return high-risk category

Also remember,

beta at very high levels probably indicates high price volatility because of low-liquidity

Formula of beta(β ) β=cov(rs,rm)var(rm) rs=rate of return of stock(for given time) rm=rate of return of market(for given time)

Calculation of beta for Tesco The beta of Tesco is calculated by the use of excel slope formula

Adj Close tesco l

Adj Close ftse 100

01-12-2010

01-11-2010

01-10-2010

01-09-2010

02-08-2010

01-07-2010

(B3/B4-1) 0

(C3/C4-1)

beta of tesco for 5yrs slope(return of tesco,return of market)

06721777

783190952

Page 8 of 25

02588455 0

022816566

006238113

616389636

069372979

065708678

507950734

01-04-2010

01-03-2010

01-02-2010

04-01-2010

01-12-2009

02-11-2009

01-10-2009

01-09-2009

03-08-2009

01-07-2009

01-06-2009

01-05-2009

01-04-2009

02-03-2009

02-02-2009

02-01-2009

01-12-2008

03-11-2008

01-10-2008

069793 412

022237482

060715286

156637854

041456521

042807328

008567269

02898206 0

017413662

045835116

24431558

02506462 0

0415196

01-072008

02-062008

03-032008

01-022008

01-012008

03-122007

01-082007

02-072007

01-062007

6308 6171

0221178 0

00509422

01-052006

03-042006

062890 663

421934 192

00926161 1

00374475 0

02988863 0

00541638 5

09018803 7

The values of beta for Tesco are as follows:YEAR

BETA VALUE OF TESCO

2006-10

783190952

507950734

156637854

008567269

24431558

Tesco The Tesco share is less volatile

This means the stock price swing less compared to market movements

The company stocks and high-liquidity stocks have beta less than one

In a long-term prospective these stocks fall under low-risk low-profit category

By keeping the share of Tesco in our portfolio,

we can minimize the risk of loss

But on the other hand we also play down the possibility of making good profit in short period of time

The share of Tesco is good to play for long term/long period,

But it not good for the professional traders,

who use to buy and sales share on daily basis

Tesco share is good for the general public,

and the peoples who don’t want to take the risk on their investment

It is not 100% safe as the Treasury bill,

LIBOR rate or any other government securities

Calculation of beta for Royal Bank of Scotland The beta of Royal Bank of Scotland is calculated by the use of excel slope formula

Adj Close rbs l

Adj Close ftse100

Page 12 of 25

(B3/B41) 0

03937 22 0

15736 4 0

06301 2 0

06796 77 0

10768 6 0

20588 95 0

11341 8 0

14020 2

01-122010

01-112010

01-062010

04-052010

04-012010

01-122009

02-112009

01-102009

10616 44 0

11995 2 0

20981 2 0

20698 8 0

08152 6 0

28539 58

23522 73 0

16803 82 0

16625 39

Page 13 of 25

(C3/C4-1) 0

0845335 59

slope(return of RBS,return of FTSE) 2

232457592

528353377

20285309

870793735

594055001

073393588

02-022009

02-012009

01-122008

03-112008

01-102008

02041 88 0

08612 4 0

70612 24 0

05603 45 0

05454 55 0

55465 6 0

10669 1 0

18074 1 0

62290 5 0

23748 7 0

10861 87 0

01511 6 0

05908 1 0

33768 1

01-072008

02-062008

02298 0

12402 6 0

00785 34

Page 14 of 25

0893772 55

03-122007

03-092007

01-082007

02-072007

01-062007

01-052007

02-042007

01-032007

01-022007

580 592

03268 0

11132 6 0

01619 0

08616 2 0

03038 0

06398 1 0

00876 49 0

02410 6 0

02723 1 0

01195 8 0

01762 1 0

02560 24 0

08319 74 0

01446 9 0

01633 99 0

03204 05 0

02241 38 0

02027 0

Page 15 of 25

0221178 0

0191481

03691 3 0

04487 2 0

07082 18 0

09843 36

41182 2

0188 04

treasury bill rate (%) 5 years rf

0054163 85

0901880 37

The values of beta for Royal Bank of Scotland are as follows:YEAR

BETA VALUE OF Royal Bank of Scotland

2006-10

528353377

20285309

870793735

594055001

073393588

The Royal Bank of Scotland share is more volatile in comparison of Tesco

This means the stock price swings more compared to market movements

Many growing companies and technology companies have beta greater than one

Most of these stocks fall under high-return high-risk category

Also remember,

beta at very high levels probably indicates high price volatility because of low-liquidity

by keeping the share of Royal Bank of Scotland in our portfolio,

But on the other hand we also increase the possibility of making good loss in short period of time

The share of Royal Bank of Scotland is good to play for short term/short period,

But it is good for the professional traders,

who use to buy and sales share on daily basis

Royal Bank of Scotland share is not good for the general public,

and the peoples who don’t want to take the risk on their investment

Because it is very volatile and it can’t be trusted

Page 17 of 25

The comparison of the beta value of Tesco and Royal Bank of Scotland

( on the basis of each year) Year

ROYAL BANK OF SCOTLAND

783190952

232457592

616389636

528353377

507950734

20285309

156637854

870793735

008567269

594055001

24431558

073393588

Royal Bank of Scotland

The share of Tesco is very less volatile

The share of Royal bank of Scotland is volatile but near to the ideal condition

The beta value the share reaches near to the ideal market situation

The share value becomes less volatile

Due to the recession period the share value becomes more volatile

Due to the recession period the share value becomes more volatile

Page 18 of 25

In this period the beta value of share becomes less volatile in comparison of others

In this year the beta value of the share reaches up to the 3

2% mark

The beta value in this year remains nearly the same as the previous year

The beta value falls down to nearly half of the previous year

But still it is more volatile than the other

As per the above the Tesco is much safer for the small investors in comparison to the Royal Bank of Scotland

But the return is also less in comparison to the Royal Bank of Scotland,

Required rate of return The CAPM establishes the linear relationship between the required rate of return of a share and its systematic or undiversified risk or beta

The rate of return can be described as the minimum rate of return that an investment must provide or must be expected to provide in order to justify its acquisition

The CAPM states that the expected return of a security or a portfolio should equal the rate on a risk-free security (Treasury bond,

LIBOR rate) plus a risk premium

If this expected return does not meet or exceed the required return,

the investment should not be undertaken

The security market line plots the results of the CAPM for all different risks (betas)

Ri=Rf+βRm-Rf

Page 19 of 25

Ri = rate of expected return Rf = risk free return (treasury bills,

libor rate) Rm =rate of market return  = beta value of company The risk free rate of return can be described as the rate of return with zero risk

It is the rate of interest an investor gets or would expect from absolute risk free investment over a specified period of time

The treasury bills,

LIBOR rate is considered as the risk free rate of return

Calculation of expected rate of return • Royal bank of Scotland Ri=Rf+βRm-Rf

Ri = rate of expected return Rf = 2

018804-2

24) Ri= 2

The investors of Page 20 of 25

the Royal Bank of Scotland expect the rate of return on the investment is about 17

Ri = rate of expected return Rf = 2

018804-2

24) Ri= 2

The investors of the Tesco expect the rate of return on the investment is about 5

Significance and assumption of CAPM The greatest advantage of Capital asset pricing model (CAPM) is the idea that risk-return relation of every portfolio can be optimized to attain lowest risk for a specific level of return

Many investors following CAPM prefer to invest in low-cost index funds rather than on stocks

CAPM necessitates diversification of portfolio

It helps the investor to select the portfolio of its choice,

whether they want to invest in low risk shares or high risk share

Or they can manage their portfolio by keeping some volatile and some less volatile shares

Page 21 of 25

Assumptions 1

If investors agree on the distribution of asset returns

If Investors have the same fixed (static) investment horizon

Investors hold efficient frontier portfolios

There is a risk-free asset: • paying interest rate rF • in zero net supply

Demand of assets equals supply in equilibrium

Acceptability or Implication of CAPM 1

The market portfolio is the tangent portfolio

Combining the risk-free asset and the market portfolio gives the portfolio frontier

The risk of an individual asset is characterized by its co variability with the market portfolio

The part of the risk that is correlated with the market portfolio,

The systematic risk cannot be diversified away

• Bearing systematic risk needs to be rewarded

The part of an asset’s risk that is not correlated with the market portfolio,

can be diversified away by holding a frontier portfolio

• Bearing non-systematic risk need not be rewarded

Conclusion Page 22 of 25

According to the calculation of betas and CAPM the share price of Royal Bank of Scotland is more volatile in nature than the share price of Tesco

According to me the Tesco is more safe option in the portfolio,

instead of Royal Bank of Scotland

for the investor who don’t want to take risk and play safe in the market

The excepted rate of return of Royal Bank of Scotland is much higher than Tesco

And for those investors who want to take the risk and earn more profit can opt for the Royal Bank of Scotland share

But they always have a risk of crashing and losing a huge amount of investment

I have to invest in a share,

I will invest in the share of Royal Bank of Scotland

so that I can earn more profit

But I also have to keep the eye on the fluctuation of the market and Royal Bank of Scotland share price

that I can minimise the risk of losing my investments

Reference http://www

html : beta (accessed on 20 march 2011) W

Sharpe,

(September 1964),

“Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk,” Journal of Finance 19 pp

Lintner,

(February 1965),

“The Valuation of Risk Assets and the Selectionof Risky Investments in Stock Portfolios and Capital Budgets,” Review of Economics and Statistics 47 pp

13–37

Page 23 of 25

Treynor’s article has not been published

Helbaek,

Morten Lindset,

Snorre Mclellan,

Brock ,

Pages: 164 : McGraw-Hill Education

Frank J

Fabozzi,

Jack Clark Francis,

The Journal of Financial and Quantitative Analysis,

Bibliography Arnold,

Corporate Financial Management,

Harlow,

Financial Times Prentice Hall

Bernstein,

Capital Ideas,

the Improbable Origins of Modern Wall Street

New York: Free Press,

Page 24 of 25

Fabozzi,

Frank J

Handbook of Portfolio Management

New York: McGraw-Hill,

MacBeth

Return,

and Equilibrium: Empirical Tests

" Journal of Political Economy,

71 (1973)

Gitman,

Lawrence

Basic Managerial Finance,

New York: Harper Collins,

Haugen,

Modern Investment Theory

Englewood Cliffs,

NJ: Prentice Hall,

Ibbotsen,

Sinquefield

and Inflation: Year-by-Year Historical Returns (1926-1974)

49 (1976)

Lintner,

"The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets

" Review of Economics and Statistics,

47 (1965)

Markowitz,

7 (1952)

"A Critique of the Asset Pricing Theory Tests—Part 1: On Past and Potential Testability of the Theory

" Journal of Financial Economics,

4 (1977)

"The Arbitrage Theory of Capital Asset Pricing

13 (1976)

Schwert,

and other Empirical Regularities

" Journal of Financial Economics,

12 (1983)

Sharpe,

"Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk

19 (1964)

Page 25 of 25