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Lecture 10 - CAPM

The document summarizes different models of risk and return, including the Capital Asset Pricing Model (CAPM), Consumption CAPM (CCAPM), and Arbitrage Pricing Theory (APT). The CAPM states that the expected return of an asset is determined by its beta, or non-diversifiable risk. It assumes investors hold efficient portfolios of risky assets and risk-free assets. The CCAPM measures risk based on how it impacts an investor's consumption. The APT does not specify risk factors but says expected returns are explained by multiple factors.

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142 views

Lecture 10 - CAPM

The document summarizes different models of risk and return, including the Capital Asset Pricing Model (CAPM), Consumption CAPM (CCAPM), and Arbitrage Pricing Theory (APT). The CAPM states that the expected return of an asset is determined by its beta, or non-diversifiable risk. It assumes investors hold efficient portfolios of risky assets and risk-free assets. The CCAPM measures risk based on how it impacts an investor's consumption. The APT does not specify risk factors but says expected returns are explained by multiple factors.

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Investments

FINA-3720

Ligang Zhong

Lecture 10 (Chapter 9)
The Capital Asset Pricing Model
Chapter Summary

• Objective: To present the basic version of the model and


its applicability.

– Assumptions
– Resulting Equilibrium Conditions
– The Security Market Line (SML)
– Applications of the CAPM
– Other Models
Standard models of risk

• All models emphasize risk-return tradeoffs


– Riskier assets should have lower prices – giving them higher
expected returns
– But over any given period, riskier asset may have a very low
realized return due to unexpected bad news

• Different models emphasize different risks


– Capital asset pricing model (CAPM)
– Consumption CAPM (CCAPM)
– Arbitrage pricing theory (APT)
CAPM

 Most popular model of expected return


 Also, embodies much intuition

 About investors:
 Investors are rational, and like higher portfolio mean return,
dislike portfolio variance.
 Called “mean-variance” investors.
 As a result, rational investors will diversify, and they don’t
particularly care about performance of any one asset. Only
care about overall portfolio return.
CAPM

 Key observations:
 Total portfolio risk depends on variance and covariance of
assets in portfolio.
 In a portfolio of two assets:

Expected Portfolio Return  (x1 E[R1 ])  ( x 2 E[R 2 ])

Portfolio Variance  x σ  x σ  2( x1x 2 σ12 )


2 2
1 1
2
2
2
2
 As get more diversified (split portfolio among many
assets), portfolio variance depends more on covariance
terms than variance terms
 x1 and x2 are the weights for the two assets.
When number of assets increases……

Expected Portfolio Return  (x1 E[R1 ])  ( x 2 E[R 2 ]  ...  x N E[R N ])

For the variance term:

2 assets: 2 variance terms, 2 covariance terms.


3 assets: 3 variance terms, 6 covariance terms.
4 assets: 4 variance terms, ?? Covariance terms.
100 assets: 100 variance terms, ?? covariance terms.
CAPM

In an equilibrium of rational mean-variance investors that


have access to a risk-free asset, we can derive that all
investors will hold market portfolio and risk free asset, and

E[ri ] = rf + i (E[rm] - rf )
where
 im
i  2
m Covariance of i with
the market risk
premium

Variance of the market risk premium


CAPM remarks

• Beta is the measure of risk for any security for a well-diversified


portfolio.

• To repeat: No E[R] reward for idiosyncratic risk

• CAPM just a one-period model. Can think of it as a prediction for


any horizon – day, week, year …

• Note: Variance is the measure of risk for a Single Security


Portfolio.
Expected Return-Beta Relationship

• CAPM holds for the overall portfolio


because: E ( r ) 
P 
w E ( r ) and
k
k k

 P   wk  k
k

• This also holds for the market portfolio:


E ( rM )  r f   M  E ( rM )  r f 
Figure 9.2: The Security Market Line
SML Relationships

= Cov(ri,rm) / m2


Slope SML = E(rm) - rf
= market risk premium
E(r)SML = rf + [E(rm) - rf]
BetaM = Cov (rM,rM) / 2
=  M2 /  M2 = 1
Disequilibrium Example

• Suppose a security with a  of 1.2 is offering expected


return of 17%
• Market expected return 14%, and risk free rate 6%
• According to SML, it should be 15.6%
• Under-priced: offering too high of a rate of return for its
level of risk
• Its alpha is 17-15.6 = 1.4%
Figure 9.3 The SML and a Positive-Alpha Stock
Application-Pricing of Stocks

• Recall the 1st lecture on definition & Pricing of Asset:


E[CFt ]
E[ P*]  
t 0 (1  E [ R ]) t

E[R] is the rational discount rate


E[CF] is the Expected Cash Flows

• For a Stock, What is the expected Cash Flow? What is


the expected Discount rate?
Application-Example

• Suppose that there is one company which will pay one terminal dividend at
the end of year one, then go out of business. The dividend is as yet unknown
but based on a thorough analysis of all public information, investors agree on
the following distribution:

Possible Dividend Probability


$10 0.3
$6 0.5
$3 0.2
• Suppose investors rationally use the CAPM to discount
• In addition, based on all public information, it is believed that Beta of the
stock is 1.3, the expected market index return is 9.5%, and riskless rate is
2.0%. Using this information, assume the market for this stock is semi-strong
efficient, what is the current price?
Application-Example

• E(r) = Expected Holding Period Return


• P0 = Beginning price
• P1 = Ending price
• D1 = Dividend during period one
• Given information on the market, you should be able to figure out the price
CCAPM

• In standard CAPM, risk of a security depends on the


risk it adds to overall portfolio wealth
– CCAPM (“Consumption CAPM”) recognizes that ultimate
purpose of wealth is to finance consumption.

• CCAPM says risk of a security depends on risk it adds


to ultimate consumption.
– So what matters is beta (covariance/var) with consumption
– High consumption beta, high risk and high expected return.
– CCAPM not used much (“whose” consumption matters?)
APT

• Arbitrage Pricing Theory starts by assuming that


Ri = a + bi1*Xfactor 1+ bi2*Xfactor 2 + … + noise

• Disadvantage: Number and nature of factors left unspecified (no


economic intuition)

• APT predicts that E[Ri] = Rf + bi1*(E[Rfactor 1] - Rf) +


bi2*(E[Rfactor 2] - Rf) + …
where E[Rfactor j] is the expected return on a portfolio whose
beta with factor j is 1 and with all others is 0
Risk models: General remarks

• Each model makes debatable assumptions


– None is “true” – just the best we have

• And each has its own implementation problems


– CAPM: Little empirical support, market index unspecified.
– CCAPM: Little empirical support, consumption unspecified.
– APT: Factors unspecified.

• Keep in mind: These are only models

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