The Capital Asset Pricing Model

Lecture 5 The Capital Asset Pricing Model
5.1 Introduction
The Capital Asset Pricing Model
• A Center-piece of modern financial economics.

• Prediction of relationship between
– The risk of an asset.
– its expected return.
• Two functions
– Benchmark rate for evaluating possible investment.
– Educated guess on expected return that are yet to be traded in the
market.
page 2 of 14
The Capital Asset Pricing Model
Assumptions
• No taxes and transaction costs.

• Investors
– Are price-takers with wealth that is small relative to total wealth in
the market.
– Focus on a single-period investment horizon.
– Can only purchase publicly traded assets.
– Can borrow and lend at the same risk-free rate.
– Are rational mean-variance optimizers, i.e., use the Markowitz Port-
folio Selection model.
– Have homogeneous expectations.
page 3 of 14
Deriving the CAPM
• Investors prefer more wealth to less

– All else equal, invest in assets that promise high returns.
• All individuals are risk-averse.
– Demand to be paid for every unit of risk that they take on.
Required Return = Risk-Free Rate+
No. Units of Risk × Risk Premium per Unit of Risk
page 4 of 14
5.2 Deriving the CAPM
Deriving the CAPM
• Being risk averse, investors will

– Diversify to reduce the risk.
– Continue to diversify until they spread their wealth across all assets
in the economy, or are fully diversified.
– Hold the market portfolio in some proportion.
▷ This portfolio will be on the efficient frontier.
▷ Will be the tangency portfolio to the optimal CAL. That is, the
Capital Market Line (CML) is the best possible CAL.
page 5 of 14
Deriving the CAPM
page 6 of 14
Deriving the CAPM
page 7 of 14
Market Risk Premium
• The risk premium on the market portfolio will be proportional to

– Risk.
– Degree of risk aversion of the investor.
E(RM ) = ĀσM2
– σM
2 : Variance of the market portfolio.
– Ā: Average degree of risk aversion across investors.
page 8 of 14
Concept Check 9.2
Data from the last eight decades for the S&P 500 index yield the fol-
lowing statistics: average excess return, 7.9%, standard deviation,
23.2%.
a. To the extent that these averages approximated investor expecta-
tions for the period, what must have been the average coefficient
of risk aversion?
b. If the coefficient of risk aversion were actually 3.5, what risk pre-
mium would have been consistent with the market’s historical stan-
dard deviation?
Solution:
a.
Ā =
E(rM ) − rf
=
0.079
= 1.47
2
σM 0.232 2
page 9 of 14
b.
E(rM ) − rf = ĀσM2 = 3.5 × 0.2322 = 0.188 = 18.8%
page 10 of 14
Deriving the CAPM
• Since they hold the market portfolio

– Investors will be concerned about how an individual asset con-
tributes to the risk of the market portfolio overall.
• In a large portfolio, covariance risk dominates.
– The covariance of the returns of the individual asset with those of a
well-diversified portfolio is the appropriate measure of an individual
asset’s riskiness.
page 11 of 14
Deriving the CAPM
• Investors demand a premium for covariance risk.

E(ri) = rf + Cov(rM , ri) × Risk Premium per Unit of Risk
= r + Cov(r , r ) ×
E (rM ) − rf
f M i 2
σM
• Defining βi as the covariance of asset i’s returns with the market scaled
by market variance yields the Sharpe-Lintner CAPM
E(ri) = rf + βi(E(rM ) − rf )
page 12 of 14
GE Example
• The market portfolio

∑ n ∑ n ∑
n
2
σM = ωiωj Cov(ri, rj ), E(RM ) = ωiE(Ri)
i=1 i=1 i=1
• Covariance of GE return with the market portfolio
∑n ∑n ∑
n
ωiCov(Ri, RGE ) = Cov(ωiRi, RGE ) = Cov( ωiRi, RGE )
i=1 i=1 i=1
• Therefore, the reward-to-risk ratio for investments in GE is
GE’s contribution to risk premium ωGE E(RGE )
=
GE’s contribution to variance ωGE Cov(RGE , RM )
=
E(RGE )
Cov(RGE , RM )
page 13 of 14
GE Example
• Equilibrium requires all investments should offer the same reward-to-

risk ratio.
E(RGE ) = E(RM )
Cov(RGE , RM ) 2
σM
• The risk premium for GE is
E(RGE ) = Cov(RGE , RM )
2
σM
E(RM )
• Rearrange terms we have

( )
E(rGE ) = rf + βGE E(rM ) − rf
page 14 of 14
5.3 Expected Return-Beta Relationship
Expected Return-Beta Relationship
• CAPM holds for the overall portfolio since

∑
E(rp) = ωk E(rk )
∑
k
βp = ωk βk
k
• This also holds for the market portfolio
E(rM ) = rf + βM [E(rM ) − rf ]
page 2 of 11
Concept Check 9.3
Suppose that 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 Toyota and 75% in Ford, if they have betas
of 1.10 and 1.25, respectively.
Solution:
βp = ωF ordβF ord + ωT oyotaβT oyota = 0.75 × 1.25 + 0.25 × 1.10 = 1.2125
The market risk premium E(rM ) − rf is 8%, the portfolio risk premium
is
E(rp) − rf = βp[E(rM ) − rf ] = 1.2125 × 8 = 9.7%.
page 3 of 11
The Security Market Line
page 4 of 11
The Security Market Line
• Importantly
– Fairly priced assets will sit exactly on the SML.
– Given the assumptions made when deriving the CAPM, all securities
must lie on the line when the market is in equilibrium.
• In reality, these assumptions may not hold.
• Securities do not have to lie on the SML.
page 5 of 11
The SML and Alpha
• Practitioners use the SML to develop an expectation of an asset’s fair

return and compare this to the return that is actually expected given
security analysis.
• The difference is the stock’s alpha.
– Stocks with an expected return greater the fair return are viewed as
underpriced.
▷ These stocks fall above the SML and have a positive alpha.
– Stocks providing an expected return less than the fair return are
viewed as overpriced.
▷ These stocks fall below the SML and have a negative alpha.
page 6 of 11
The SML and Alpha
page 7 of 11
5.4 The CAPM and the Single-Index Market
The CAPM and the Single-Index Market
• Two key implication of the CAPM
– The market portfolio is efficient.
– The risk premium on a risky asset is proportional to its beta.
• Testing whether these implications are supported empirically involves
– Constructing a value-weighted portfolio comprising all risky assets
(the market portfolio) and testing its mean-variance efficiency.
▷ Problematic given the market portfolio is not observable.
▷ Even it were observable, its expected returns cannot be observed
directly.
– Seeing whether the expected return-beta relationship holds for in-
dividual assets.
▷ Problematic again given it involves expected returns.
page 8 of 11
The CAPM and the Single-Index Market
• CAPM involves expected returns but we can only observe realized

returns.
– We can use the Single-Index model to derive expected return from
observed returns.
– Defining Ri (RM ) as the excess return on stock i (the market index),
the single-index model can be defined as
Ri = αi + βiRM + ei
– We can estimate this relationship using regression analysis and ob-
served returns over a sample period.
page 9 of 11
The CAPM and the Index Model
• Notice that the covariance between the excess return on security i and
the market index is
Cov(Ri, RM ) = Cov(βiRM + ei, RM )
= βiCov(RM , RM ) + Cov(ei, RM )
2
= βiσM
Cov(Ri, RM )
βi = 2
σM
• The beta coefficient from the index model is the same as the CAPM
except the observable market index replaces the CAPM’s theoretical
market portfolio.
page 10 of 11
The CAPM and the Index Model
• Unlike the Index Model, the CAPM predicts that αi will be zero for all
assets.
• Why is the case?
– Imagine the index M represents the true market portfolio.
– Taking expectations of the single-index model specification yields
E(ri) − rf = αi + βi(E(rM ) − rf )
– Comparing this to the CAPM below
E(ri) − rf = βi(E(rM ) − rf )
– αi = 0 for all i.
page 11 of 11
Other CAPM Extensions
• The Inter-temporal CAPM (ICAPM)

– Merton generalized the single-period CAPM to a multi-period set-
ting.
• The Consumption-Based CAPM (CCAPM)
– Breeden incorporated consumption into the relationship between
risk and expected return.
• Many others.
page 23 of 23

The Capital Asset Pricing Model

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Lecture 5 The Capital Asset Pricing Model

• A Center-piece of modern ﬁnancial economics.

• No taxes and transaction costs.

• Investors prefer more wealth to less

Deriving the CAPM

• Being risk averse, investors will

• The risk premium on the market portfolio will be proportional to

– Ā: Average degree of risk aversion across investors.

• Since they hold the market portfolio

• Investors demand a premium for covariance risk.

• The market portfolio

• Equilibrium requires all investments should offer the same reward-to-

• Rearrange terms we have

Expected Return-Beta Relationship

• CAPM holds for the overall portfolio since

• Practitioners use the SML to develop an expectation of an asset’s fair

• CAPM involves expected returns but we can only observe realized

• The Inter-temporal CAPM (ICAPM)

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