Investments

CHAPTER 9
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The Capital Asset Pricing Model

Slides by Richard D. Johnson
McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

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Capital Asset Pricing Model (CAPM) It is the equilibrium model that underlies all modern financial theory. Set of predictions (based upon assumptions) regarding the equilibrium rate of return on risky assets Derived using principles of diversification Markowitz, Sharpe, Lintner and Mossin are researchers credited with its development.
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Assumptions Individual investors are price takers. Single-period investment horizon. Investments are limited to traded financial assets. Investors may borrow or lend any amount at a fixed risk-free rate (same rf) No taxes and transaction costs.

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Assumptions (contd) Information is costless and available to all investors. Investors are rational mean-variance optimizers how? There are homogeneous expectations.

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Resulting Equilibrium Conditions All investors will hold the same portfolio for risky assets market portfolio. Market portfolio contains all securities and the proportion of each security is its market value as a percentage of total market value.

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What is M? C = P + F F = 0 (why?) C = P = entire wealth of the economy C = P = M Investors hold identical risky portfolios given assumptions of the CAPM: identical Markowitz analysis, same input lists, same securities, same horizon
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Figure 9.1 The Efficient Frontier and the Capital Market Line

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Resulting Equilibrium Conditions (contd) Risk premium on the the market depends on the average risk aversion of all market participants mathematically: E(rm) rf = *m * 0.01

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Risk Premium of M Recall each individual investor chooses y, such that:

y = (E(rm) rf) / (0.01*A*m)
Hence the AVERAGE position in the risky

portfolio is 100% or y=1

E(rm) rf = 0.01* * m

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Resulting equilibrium conditions contd

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Risk premium on an individual security is a function of its covariance with the market. E(ri) rf = i * {E(rm)-rf}

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Interpreting the Beta co-efficient is defined relative to the market portfolio it is a measure of the extent to which returns on security i and the market portfolio move together formally: i = cov(ri,rm)/cov(rm,rm)

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Expected Returns on Individual Securities CAPM built upon the insight that risk premium on a security is determined by its contribution to the investors overall portfolio Portfolio risk is what matters not individual risk when making decisions at the margin (security selection) Contribution to portfolio risk governs the risk premium demanded on a SINGLE security
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Return and Risk For Individual Securities The risk premium on individual securities is a function of the individual securitys contribution to the risk of the market portfolio. An individual securitys risk premium is a function of the covariance of returns with the assets that make up the market portfolio.

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Figure 9.2 The Security Market Line

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Example Suppose the risk premium on the market portfolio is estimated at 8% with a standard deviation of 22%. What is the risk premium on a portfolio invested 25% in GM and 75% in Ford, if they have betas of 1.10 and 1.25 respectively?

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Alphas The difference between the fair expected return as given by the SML and the actual expected return based on own analysis/belief is called the assets alpha Alpha = Actual belief - Fair If Alpha>0, asset is UNDERPRICED and plots ABOVE SML If Alpha <0, asset is OVERPRICED and plots BELOW SML
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Figure 9.3 The SML and a Positive-Alpha Stock

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Example Analysts expect a return of 12% on Stock A and 13% on Stock B. The s of the two stocks are 1 and 1.5 respectively. The markets expected return is 11% and rf= 5%. According to CAPM which stock is a better buy? What is the alpha of each stock? Plot the SML and show the alphas graphically
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Suppose E(rm) = 16% and rf = 8%. A firm is considering an investment project having a beta of 1.3 What is the (fair) required rate of return on the project? If the (actual) expected rate of return, say IRR, is 19% should it be accepted?

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The CAPM and Reality Is the condition of zero alphas for all stocks as implied by the CAPM met?
Not perfect but one of the best available

Is the CAPM testable?

Proxies must be used for the market portfolio

CAPM is still considered the best available description of security pricing and is widely accepted
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CAPM with restricted borrowing: Zero-Beta Model

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CAPM was based on the assumption of a common P = M When borrowing is restricted, M is not the common optimal risky portfolio

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Assumptions of Zero-Beta Model Combinations of portfolios on the efficient frontier are efficient All frontier portfolios have companion portfolios that are uncorrelated Returns on individual assets can be expressed as linear combinations of efficient portfolios

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E(r)

Q P E[rz (Q)] E[rz (P)] Z(Q) Z(P) s

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E (ri ) E (rQ ) E (rP ) E (rQ )

Cov(ri , rP ) Cov(rP , rQ )
2 s P Cov(rP , rQ )

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CAPM with E(rz(m)) replacing rf

Cov(ri , rM ) E (ri ) E (rZ ( M ) ) E (rM ) E (rZ ( M ) ) 2 sM

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Question Suppose the zero-beta portfolio exhibits returns that are on average greater than the risk-free rate. Does this question the validity of CAPM?

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