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Capital Asset Pricing Model

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Capital Market Theory
• Capital market theory extends portfolio theory
and develops a model for pricing all risky assets
Capital Asset Pricing Model (CAPM)
• CAPM determines the required rate of return
for any risky asset

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 Capital Market Theory
Capital market theory
• makes some assumptions about investors and capital
markets
• Introduces the concept of a risk-free asset
 An asset with zero standard deviation
 Zero correlation with all other risky assets
 Provides the risk-free rate of return (RFR)*
 Will lie on the vertical axis of a portfolio graph

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 The Capital Market Line (CML)

Combining a risk-free asset with a risky portfolio, M:

• Expected return is:

• Standard deviation is:

σRF =0 so σport =(1-WRF) σM

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 The Capital Market Line
Substituting for WRF :

Which holds for every combination of the risk-free

asset with any collection of risky assets

When the risky portfolio, M, is the ‘Market portfolio’

containing all risky assets held anywhere in the
marketplace, this linear relationship is called the
capital market line.*

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CML

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 Developing the Capital Market Line
• Risk-return possibilities with leverage
– With the risk-free asset, one can add leverage to
the portfolio by borrowing money at the risk-free
rate and investing in the risky portfolio at point M
to achieve a point like E

– Clearly, point E dominates point D

– Similarly, one can reduce the investment risk by

lending money at the risk-free asset to reach
points like C

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CML with leverage

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 The Market Portfolio
• The market portfolio
– Because portfolio M lies at the point of tangency, it
has the highest portfolio possibility line
– Everybody will want to invest in Portfolio M and
borrow or lend to be somewhere on the CML
– It must include ALL RISKY ASSETS
– Because it contains all risky assets, it is a
completely diversified portfolio, which means that
all the unique risk of individual assets
(unsystematic risk) is diversified away

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 Risk and the Market Portfolio
• Systematic risk (or market risk):
– It is the only risk in the market portfolio
– it is the variability in all risky assets caused by
macroeconomic variables
 Variability in growth of money supply
 Interest rate volatility
 Variability in factors like (1) industrial production (2)
corporate earnings (3) cash flow
– it can be measured by the standard deviation of
returns of the market portfolio and can change
over time

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 Risk, Diversification and the Market
Portfolio
• Diversification and the elimination of
unsystematic risk
– The purpose of diversification is to reduce the
standard deviation of the total portfolio
– This assumes that imperfect correlations exist
among securities
– As you add securities, you expect the average
covariance for the portfolio to decline
– How many securities must you add to obtain a
completely diversified portfolio?

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Moving towards a completely diversified portfolio

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 The Capital Asset Pricing Model
(CAPM)
Assumptions include:
• All investors are fully diversified
• Investors have the same expectations of a
security’s future returns
• Many investors, none of them large enough for
their individual trades to affect prices
• Investors have same holding period
• No transaction taxes, no commissions

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The Capital Asset Pricing Model
(CAPM)
– CAPM shows the relationship between risk and
return for individual asset (or any portfolio)

– For an individual asset i, the relevant risk measure

is σi riM, where riM is the correlation coefficient
between the asset and the market

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 CAPM
Applying the CML using this relevant risk measure

βi=(σi riM) / σM is the asset beta

beta measures the systematic risk

The CAPM determines the required or expected rates

of return on risky assets

Return from any asset = risk free rate + risk premium

E(RM – RFR) is equity risk premium
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Security Market Line

CAPM
E(Ri) = RFR + βi (E(RM) – RFR)

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 CAPM

• Example: Determining the expected rate of return

– Risk-free rate is 5% and the market return is 9%
Stock A B C D E
Beta 0.701.001.151.40-0.30

– Applying
E(RA) = 0.05 + 0.70 (0.09-0.05) = 0.078 = 7.8%
E(RB) = 0.05 + 1.00 (0.09-0.05) = 0.090 = 09.0%
E(RC) = 0.05 + 1.15 (0.09-0.05) = 0.096 = 09.6%
E(RD) = 0.05 + 1.40 (0.09-0.05) = 0.106 = 10.6%
E(RE) = 0.05 + -0.30 (0.09-0.05) = 0.038 = 03.8%

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 CAPM
• Identifying undervalued and overvalued assets
– In equilibrium, all assets and all portfolios of assets
should plot on the SML
– But sometimes stock lie above of below the SML
– Any security with an estimated return that plots
above the SML is underpriced
– Any security with an estimated return that plots
below the SML is overpriced
– A superior investor must derive value estimates for
assets that are consistently superior to the
consensus market evaluation to earn better risk-
adjusted rates of return than the average investor
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 CAPM
– Compare the required rate of return to the
estimated rate of return for a specific risky asset
using the SML over a specific investment horizon
to determine if it is an appropriate investment

Stock Required Return (CAPM) Estimated Return

A 7.8% 8.0%
B 9.0% 6.2%
C 9.6% 15.15%
D 10.6% 5.15%
E 3.8% 6.0%

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SML: Under-priced or Over-priced Assets

A, C, E under-priced

α
B, D over-priced

Alpha is the difference between the actual return and the

expected return given by CAPM

αi = Ri – [RFR + βi (E(RM )- RFR)]

Where Ri is the estimated or actual return

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 CAPM
Calculating systematic risk
• The formula for beta:
si Cov ( Ri , RM )
bi = riM =
sM s M2

Beta shows the sensitivity of the stock i to the market

The characteristic line
 A regression line between the returns to the security (Rit)
over time and the returns (RMt) to the market portfolio

 The slope of the regression line is beta

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Characteristic Line

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 Empirical Tests of the CAPM
• Stability of beta
– Betas for individual stocks are not stable
– Portfolio betas are reasonably stable
– The larger the portfolio of stocks and longer the
period, the more stable the beta of the portfolio
– High-beta portfolios tend to decline over time
toward 1 whereas low-beta portfolio tend to
increase over time toward 1
– Trading volumes may affect the beta stability

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CAPM Example:

(a) If the expected return from the market is 15% and

the risk-free rate is 4%, calculate the expected return
from a stock with a beta of 2.

(b) What is the alpha of the stock if the actual return

was 25%.

(c) If the market actually fell by 12%, calculate the

expected return.

(d) If the actual return was -25%, what is the alpha?

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CAPM example- Solution

(a) If the expected return from the market is 12% and the risk-free rate is 4%,
calculate the expected return from a stock with a beta of 2.

R = 4% + 2(12%-4%) = 20%

(b) What is the alpha of the stock if the actual return was 25%.

α = 25% - 20% = 5%

(c) If the market actually fell by 12%, calculate the expected return
R = 4% + 2 (-12% - 4%) = -28%

(d) If the actual return was -25%, what is the alpha?

α = -25% - ( -28%) = 3%

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