Professional Documents
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CORPORATE FINANCE
Laurence Booth • W. Sean Cleary
Prepared by
Ken Hartviksen
CHAPTER 9
The Capital Asset Pricing
Model (CAPM)
Lecture Agenda
• Learning Objectives
• Important Terms
• The New Efficient Frontier
• The Capital Asset Pricing Model
• The CAPM and Market Risk
• Alternative Asset Pricing Models
• Summary and Conclusions
– Concept Review Questions
– Appendix 1 – Calculating the Ex Ante Beta
– Appendix 2 – Calculating the Ex Post Beta
characteristics
The first Portfolio Components Portfolio Characteristics
for all
The 100
second Expected Standard
combination
portfolios.
portfolio Weight of A Weight of B Return Deviation
simply99%
assumes 100% 0% 8.00% 8.7%
99% 1% 8.02% 8.5%
inNext
assumes plot1%
A and the
you
in 98% 2% 8.04% 8.4%
returns
B. Notice onthe
a
invest
graph
solely
(see in
increase the
97%
96%
3%
4%
8.06%
8.08%
8.2%
8.1%
innext
Asset
return slide)
and A
the 95% 5% 8.10% 7.9%
94% 6% 8.12% 7.8%
decrease in 93% 7% 8.14% 7.7%
portfolio risk! 92% 8% 8.16% 7.5%
91% 9% 8.18% 7.4%
90% 10% 8.20% 7.3%
89% 11% 8.22% 7.2%
12.00%
Correlation
Expected Return of the
10.00%
8.00%
Portfolio
6.00%
4.00%
2.00%
0.00%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0%
Standard Deviation of Returns
8 - 10 FIGURE
A is not attainable
B,E lie on the
efficient frontier and
are attainable
A B E is the minimum
variance portfolio
C (lowest risk
combination)
C, D are
E attainable but are
%nr ut e R det ce px E
D dominated by
superior portfolios
that line on the line
above E
Standard Deviation (%)
ERp
10 Achievable
Risky Portfolio
Combinations
ERp
30 Risky Portfolio
Combinations
The highlighted
portfolios are
ERp ‘efficient’ in that
they offer the
highest rate of
E is the return for a given
minimum level of risk.
variance Rationale investors
portfolio Achievable Set of will choose only
Risky Portfolio from this efficient
Combinations set.
Efficient
ERp frontier is the
set of
achievable
portfolio
combinations
Achievable Set of that offer the
Risky Portfolio
Combinations
highest rate
of return for a
given level of
E
risk.
9 - 1 FIGURE
Figure 9 – 1
illustrates
Efficient Frontier three
ER
achievable
portfolio
combinations
B
that are
A ‘efficient’ (no
other
achievable
MVP portfolio that
offers the
same risk,
Risk offers a higher
return.)
9 - 2 FIGURE
This means
you can 9 – 2
Equation
Rearranging 9
ER achieve
illustrates any
-2 where w=σ
portfolio
what you can
p / σA and
combination
see…portfolio
substituting in
σ pA =) - w
E(R RFσA along
risk the blue
increases
[9-3] ER P[9-2]
= RF + σ P Equation 1 we
σ coloured
in line
A A getdirect
an
simply
proportionby to
equation for a
changing
the amount the
RF straight line
relative
invested weight
with a in the
of RFasset.
risky and A in
constant
the two asset
slope.
portfolio.
Risk
9 - 3 FIGURE
Which risky
portfolio
ER would a
rational risk-
T
averse
investor
A choose in the
presence of a
RF
RF investment?
Portfolio A?
Tangent
Risk Portfolio T?
9 - 3 FIGURE
Clearly RF with
T (the tangent
portfolio) offers
ER a series of
portfolio
combinations
T
that dominate
A those produced
by RF and A.
Further, they
RF
dominate all but
one portfolio on
the efficient
Risk frontier!
9 - 3 FIGURE
Portfolios
between RF
and T are
Lending Portfolios ‘lending’
ER
portfolios,
because they
T
are achieved by
A investing in the
Tangent
Portfolio and
RF lending funds to
the government
(purchasing a
T-bill, the RF).
Risk
9 - 3 FIGURE
The line can be
extended to risk
levels beyond
Lending Portfolios Borrowing Portfolios ‘T’ by
ER
borrowing at RF
and investing it
T
in T. This is a
A levered
investment that
increases both
RF risk and
expected return
of the portfolio.
Risk
σρ
– Uses include:
• Determining the cost of equity capital.
• The relevant risk in the dividend discount model to estimate a stock’s intrinsic
(inherent economic worth) value. (As illustrated below)
COVi,M D1
βi =
σ M2
ki = RF + ( ERM − RF ) β i P0 = Is the stock
kc − g fairly priced?
ER
CML
σM
ER M - RF
[9-4] Slope of the CML =
σM
ERM - RF
[9-5] E ( RP ) = RF + σ P
σM
– Where:
• ERM = expected return on the market portfolio M
• σM = the standard deviation of returns on the market portfolio
• σP = the standard deviation of returns on the efficient portfolio being
considered
9 - 6 FIGURE
C is an
A
B a portfolio
overvalued
that
undervalued
offers
portfolio.
andExpected
expected
Required portfolio.
return equal
is less
Expected
tothan
the
Return on C
ER CML return
required
the required
is greater
return.
return.
than the required
Expected
A Selling pressure
return on A return.
will cause the price
Demand
to fall andfor
the yield
C Portfolio
to rise until
A will
Required increase driving
expected equalsup
return on A
B the required
price, andreturn.
therefore the
Expected
Return on C expected return will
RF
fall until expected
equals required
(market equilibrium
condition is
achieved.)
σρ
– William Sharpe identified a ratio that can be used to assess the risk-adjusted
performance of managed funds (such as mutual funds and pension plans).
– It is called the Sharpe ratio:
ER P - RF
[9-6] Sharpe ratio =
σP
Return σP Sharpe β
Source: Adapted from L. Kryzanowski, S. Lazrak, and I. Ratika, " The True
Cost of Income Trusts," Canadian Investment Review19, no. 5 (Spring
2006), Table 3, p. 15.
9 - 7 FIGURE
Market or
systematic
Unique (Non-systematic) Risk
risk is risk
that cannot
be eliminated
from the
portfolio by
investing the
Market (Systematic) Risk
portfolio into
more and
different
securities.
Number of Securities
4 The
Theslope
plotted of
the
points
regression
are the
line
coincident
is beta.
2
rates of return
earned
The lineon of
the
0 investment
best fit is
-6 -4 -2 0 2 4 6 8 andknown
the market
in
( s nr ut e Rt ekr a M
-2 finance
portfolioasover
the
characteristic
past periods.
line.
-4
-6
) %
CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 54
The Formula for the Beta Coefficient
COVi,M ρ i , M σ i
[9-7] βi = =
2
σM σM
• The beta of a security compares the volatility of its returns to the volatility of the
market returns:
Source: Res earch Insight, Com pustat North Am erican database, June 2006.
[9-8] β P = wA β A + wB β B + ... + wn β n
[9-9] ki = RF + ( ERM − RF ) β i
– Where:
ki = the required return on security ‘i’
ERM – RF = market premium for risk
Βi = the beta coefficient for security ‘i’
9 - 9 FIGURE
ER ki = RF + ( ER M − RF ) βi
M TheSML
The SMLis
ERM uses
usedtheto
beta
predict
coefficient
required as
the measure
returns for
of relevant
individual
RF
risk.
securities
βM = 1 β
9 - 10 FIGURE
Similarly,
Required
A is an returns
B is an
ER ki = RF + ( ER M − RF ) βi are forecast using
undervalued
overvalued
this equation.
security
security. because
SML its expected return
You can see
Investor’s willthat
sell
is greater than the
thelock
to required
in gains,return
required return.
Expected A on any
but the security
selling is
Return A
a functionwill
Investors
pressure will
of its
Required
Return A B
systematic
‘flock’
cause to
theA market
and
risk bid
(β)
RF andthe
up
price market
toprice
fall,
factors the
causing (RF and
expected
market
return
expected to fallreturn
till itto
premium
equals
rise untilthe for
it equals
βA βB β risk)
required
the requiredreturn.
return.
CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 62
The CAPM in Summary
The SML and CML
– Underlying factors represent broad economic forces which are inherently unpredictable.
– Where:
• ERi = the expected return on security i
• a0 = the expected return on a security with zero systematic risk
• bi = the sensitivity of security i to a given risk factor
• Fi = the risk premium for a given risk factor
– The model demonstrates that a security’s risk is based on its sensitivity to broad
economic forces.
APPENDIX 1
Calculating a Beta Coefficient Using Ex Ante
Returns
Covariance of Returns between stock ' i' returns and the market
Beta =
Variance of the Market Returns
COVi,M ρ i , M σ i
[9-7] βi = =
2
σM σM
• What does the term “relevant risk” mean in the context of the CAPM?
– It is generally assumed that all investors are wealth maximizing risk
averse people
– It is also assumed that the markets where these people trade are highly
efficient
– In a highly efficient market, the prices of all the securities adjust instantly
to cause the expected return of the investment to equal the required
return
– When E(r) = R(r) then the market price of the stock equals its inherent
worth (intrinsic value)
– In this perfect world, the R(r) then will justly and appropriately
compensate the investor only for the risk that they perceive as
relevant…
– Hence investors are only rewarded for systematic risk.
NOTE: The amount of systematic risk varies by investment. High systematic risk
occurs when R-square is high, and the beta coefficient is greater than 1.0
Cov(k i k M )
Beta =
Var(k M )
You need to calculate the covariance of the returns between the
stock and the market…as well as the variance of the market
returns. To do this you must follow these steps:
• Calculate the expected returns for the stock and the market
• Using the expected returns for each, measure the variance
and standard deviation of both return distributions
• Now calculate the covariance
• Use the results to calculate the beta
Possible
Future State Possible Possible
of the Returns on Returns on
Economy Probability the Stock the Market
Boom 25.0% 28.0% 20.0%
Normal 50.0% 17.0% 11.0%
Recession 25.0% -14.0% -4.0%
100.0%
n _ _
[8-12] COV AB = ∑ Prob i (k A,i − ki )(k B ,i - k B )
i =1
The formula for the correlation coefficient between the returns on the stock
and the returns on the market is:
COV AB
[8-13] ρAB =
σ AσB
The correlation coefficient will always have a value in the range of +1 to -1.
+1 – is perfect positive correlation (there is no diversification potential when combining
these two securities together in a two-asset portfolio.)
- 1 - is perfect negative correlation (there should be a relative weighting mix of these two
securities in a two-asset portfolio that will eliminate all portfolio risk)
Using the expected return (mean return) and given data measure the
deviations for both the market and the stock and multiply them
together with the probability of occurrence…then add the products
up.
Now you can substitute the values for covariance and the
variance of the returns on the market to find the beta of
the stock:
CovS,M .01335
Beta = = = 1.8
VarM .007425
Since the variance of the returns on the market is = .007425 …the beta for
the market is indeed equal to 1.0 !!!
Cov MM .007425
Beta = = = 1 .0
Var(R M ) .007425
% Return
E(Rs) = 5.0%
R(ks) = 4.76%
SML
E(kM)= 4.2%
Risk-free Rate = 3%
% Return
Risk-free Rate = 3%
B M= BS = 1.464
1.0
APPENDIX 2
The Regression Approach to Measuring the
Beta
• You need to gather historical data about the stock and the market
• You can use annual data, monthly data, weekly data or daily data.
However, monthly holding period returns are most commonly used.
• Daily data is too ‘noisy’ (short-term random volatility)
• Annual data will extend too far back in to time
• You need at least thirty (30) observations of historical data.
• Hopefully, the period over which you study the historical returns of the
stock is representative of the normal condition of the firm and its
relationship to the market.
• If the firm has changed fundamentally since these data were produced
(for example, the firm may have merged with another firm or have
divested itself of a major subsidiary) there is good reason to believe
that future returns will not reflect the past…and this approach to beta
estimation SHOULD NOT be used….rather, use the ex ante approach.
CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 99
Historical Beta Estimation
The Approach Used to Create the Characteristic Line
In this example, we have regressed the quarterly returns on the stock against the
quarterly returns of a surrogate for the market (TSE 300 total return composite
index) and then using Excel…used the charting feature to plot the historical
points and add a regression trend line.
The ‘cloud’ of plotted points
Period HPR(Stock) HPR(TSE 300)
represents
2006.4
‘diversifiable
-4.0% 1.2%
or company C harac teristic L ine (Regression)
30.0%
specific’ -16.0%
2006.3 risk in the securities
-7.0% returns
25.0%
that can be
2006.2 eliminated
32.0% from a portfolio
12.0%
20.0%
2006.1 through diversification.
16.0% 8.0% Since
Returns on Stock
15.0%
2005.4 company-specific
-22.0% risk can be
-11.0%
2005.3 15.0%investors16.0% 10.0%
eliminated, don’t require
2005.2 28.0%
compensation for 13.0%
it according to 5.0%
2005.1 19.0% 7.0% 0.0%
Markowitz Portfolio Theory.
2004.4 -16.0% -4.0% -40.0% -20.0% -5.0%0.0% 20.0% 40.0%
2004.3 8.0% 16.0%
-10.0%
2004.2 -3.0% -11.0%
The regression
2004.1 34.0%
line 25.0%
is a line of ‘best -15.0%
fit’ that describes the inherent Returns on TSE 300
relationship between the returns on
the stock and the returns on the
market. The slope is the beta
coefficient.
Characteristic
Returns on
Line for Imperial
Imperial
Tobacco
Tobacco %
• High alpha
• R-square is very
low ≈ 0.02
• Beta is largely
irrelevant
Returns on
the Market %
(S&P TSX)
Characteristic
Returns on
Line for GM
General
Motors % (high R2)
• Positive alpha
• R-square is
very high ≈ 0.9
• Beta is positive
and close to 1.0
Returns on
the Market %
(S&P TSX)
Returns on
the Market %
(S&P TSX)
Process:
– Go to http://ca.finance.yahoo.com
– Use the symbol lookup function to search for the
company you are interested in studying.
– Use the historical quotes button…and get 30 months
of historical data.
– Use the download in spreadsheet format feature to
save the data to your hard drive.
Volume of
Opening price per share, the trading done
The day, highest price per share during the in the stock on
month and month, the lowest price per share the TSE in the
year achieved during the month and the month in
closing price per share at the end numbers of
of the
CHAPTER 9 – month
The Capital Asset Pricing Model (CAPM) board 9lots
- 113
Spreadsheet Data From Yahoo
Alcan Example
Da te Close
01-M ay-02 59.22
01-A pr-02 57.9
01-M ar-02 63.03
01-Feb-02 64.86
02-Jan-02 61.85
Closing P rice Ca sh
Issue d for Alca n Divide nds
Da te Ca pita l AL.TO pe r S ha re
01-M ay-02 321,400,589 $59.22 $0.00
01-A pr-02 321,400,589 $57.90 $0.15
01-M ar-02 321,400,589 $63.03 $0.00
01-Feb-02 321,400,589 $64.86 $0.00
02-Jan-02 160,700,295 $123.70 $0.30
01-Dec -01 160,700,295 $119.30 $0.00
Number of shares doubled and share price fell by half between
January and February 2002 – this is indicative of a 2 for 1 stock split.
CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 116
Normalizing the Raw Company Data
Alcan Example
Closing
Price for Cash
Issued Alcan Dividends Adjustment Normalized Normalized
Date Capital AL.TO per Share Factor Stock Price Dividend
01-May-02 321,400,589 $59.22 $0.00 1.00 $59.22 $0.00
01-Apr-02 321,400,589 $57.90 $0.15 1.00 $57.90 $0.15
01-Mar-02 321,400,589 $63.03 $0.00 1.00 $63.03 $0.00
01-Feb-02 321,400,589 $64.86 $0.00 1.00 $64.86 $0.00
02-Jan-02 160,700,295 $123.70 $0.30 0.50 $61.85 $0.15
01-Dec-01 145,000,500 $111.40 $0.00 0.45 $50.26 $0.00
Normalized Normalized ( P1 − P0 ) + D1
HPR =
Date Stock Price Dividend HPR P0
$59.22 - $57.90 + $0.00
01-May-02 $59.22 $0.00 2.28% =
$57.90
01-Apr-02 $57.90 $0.15 -7.90%
= 2.28%
01-Mar-02 $63.03 $0.00 -2.82%
01-Feb-02 $64.86 $0.00 4.87%
02-Jan-02 $61.85 $0.15 23.36%
01-Dec-01 $50.26 $0.00
Ending
Norm a lize d Norm a lize d TS X
Da te S tock P rice Divide nd HP R V a lue
01-M ay-02 $59.22 $0.00 2.28% 16911.33
01-A pr-02 $57.90 $0.15 -7.90% 16903.36
01-M ar-02 $63.03 $0.00 -2.82% 17308.41
01-Feb-02 $64.86 $0.00 4.87% 16801.82
02-Jan-02 $61.85 $0.15 23.36% 16908.11
01-Dec-01 $50.26 $0.00 16881.75
( P1 − P0 )
HPR =
P0
16,911.33 - 16,903.36
Ending
=
Norm a lize d Norm a liz e d 16,903.36 TS X HP R on
= 0.05%
Da te S tock P rice Divide nd HP R V a lue the TS X
01-M ay-02 $59.22 $0.00 2.28% 16911.33 0.05%
01-A pr-02 $57.90 $0.15 -7.90% 16903.36 -2.34%
01-M ar-02 $63.03 $0.00 -2.82% 17308.41 3.02%
01-Feb-02 $64.86 $0.00 4.87% 16801.82 -0.63%
02-Jan-02 $61.85 $0.15 23.36% 16908.11 0.16%
01-Dec-01 $50.26 $0.00 16881.75
Ending
Norm a lize d Norm a liz e d TS X HP R on
Da te S tock P rice Divide nd HP R V a lue the TS X
01-M ay-02 $59.22 $0.00 2.28% 16911.33 0.05%
01-A pr-02 $57.90 $0.15 -7.90% 16903.36 -2.34%
01-M ar-02 $63.03 $0.00 -2.82% 17308.41 3.02%
01-Feb-02 $64.86 $0.00 4.87% 16801.82 -0.63%
02-Jan-02 $61.85 $0.15 23.36% 16908.11 0.16%
01-Dec-01 $50.26 $0.00 16881.75
The dependent
independentvariable
variableis isthe
thereturns
returnsononthe
theStock.
Market.
CoefficientsStandard Error t Stat P-value Lower 95% Upper 95% Lower 95.0%Upper 95.0%
Intercept 59.3420816 2.8980481 20.4765686 3.3593E-05 51.29579335 67.38836984 51.2957934 67.38837
X Variable 1 3.55278937 33.463777 0.10616821 0.920560274 -89.35774428 96.46332302 -89.3577443 96.46332