The Capital Asset

Pricing Model
(CAPM)
Chapter 10
Individual Securities

The characteristics of individual securities

that are of interest are the:
Expected Return
Variance and Standard Deviation
Covariance and Correlation
Expected Return, Variance, and
Covariance
Rate of Return
Scenario Probability Stock fund Bond fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%

Consider the following two risky asset

world. There is a 1/3 chance of each state of
the economy and the only assets are a
stock fund and a bond fund.
Expected Return, Variance, and
Covariance

Stock fund Bond Fund

Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
Expected Return, Variance, and
Covariance
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

E (rS ) 1 (7%) 1 (12%) 1 (28%)

3 3 3
E (rS ) 11%
Expected Return, Variance, and
Covariance
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

E (rB ) 1 (17%) 1 (7%) 1 (3%)

3 3 3
E (rB ) 7%
Expected Return, Variance, and
Covariance
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

(7% 11%) 3.24%

2
Expected Return, Variance, and
Covariance
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

(12% 11%) .01%2

10.2 Expected Return, Variance,
and Covariance
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

1
2.05% (3.24% 0.01% 2.89%) 14.3% 0.0205
3
The Return and Risk for
Portfolios
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

Note that stocks have a higher expected return than bonds

and higher risk. Let us turn now to the risk-return tradeoff
of a portfolio that is 50% invested in bonds and 50%
invested in stocks.
The Return and Risk for
Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

The rate of return on the portfolio is a weighted average of

the returns on the stocks and bonds in the portfolio:
rP wB rB wS rS
5% 50% (7%) 50% (17%)
The Return and Risk for
Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

The expected rate of return on the portfolio is a weighted

average of the expected returns on the securities in the
portfolio. E (rP ) wB E (rB ) wS E (rS )
9% 50% (11%) 50% (7%)
The Return and Risk for
Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
The variance of the rate of return on the two risky assets
portfolio is
P2 (wB B ) 2 (wS S ) 2 2(wB B )(wS S ) BS
where BS is the correlation coefficient between the returns
on the stock and bond funds.
10.3 The Return and Risk for
Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

Observe the decrease in risk that diversification offers.

An equally weighted portfolio (50% in stocks and 50%
in bonds) has less risk than stocks or bonds held in
isolation.
10.4 The Efficient Set for
Two Assets
% in stocks Risk Return
Portfolo Risk and Return Combinations
0% 8.2% 7.0%
5% 7.0% 7.2% 12.0%

Portfolio Return
10% 5.9% 7.4% 11.0%
15% 4.8% 7.6% 10.0% 100%
20% 3.7% 7.8% 9.0% stocks
25% 2.6% 8.0% 8.0%
30% 1.4% 8.2% 7.0%
35% 0.4% 8.4% 100%
6.0%
40% 0.9% 8.6% bonds
5.0%
45% 2.0% 8.8%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
50.00% 3.08% 9.00%
55% 4.2% 9.2% Portfolio Risk (standard deviation)
60% 5.3% 9.4%
65%
70%
6.4%
7.6%
9.6%
9.8%
We can consider other
75% 8.7% 10.0% portfolio weights besides
80% 9.8% 10.2%
85% 10.9% 10.4% 50% in stocks and 50% in
90% 12.1% 10.6% bonds
95% 13.2% 10.8%
100% 14.3% 11.0%
10.4 The Efficient Set for
Two Assets
% in stocksPortfolo Risk and Return Combinations
Risk Return
0% 8.2% 7.0%
5% 7.0% 7.2% 12.0%

Portfolio Return
10% 5.9% 7.4% 11.0%
15% 4.8% 7.6% 10.0% 100%
20% 3.7% 7.8% 9.0% stocks
25% 2.6% 8.0% 8.0%
30% 1.4% 8.2% 7.0% 100%
35% 0.4% 8.4% 6.0% bonds
40% 0.9% 8.6% 5.0%
45% 2.0% 8.8% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
50% 3.1% 9.0%
55% 4.2% 9.2% Portfolio Risk (standard deviation)
60% 5.3% 9.4%
65% 6.4% 9.6% Note that some portfolios are
70%
75%
7.6%
8.7%
9.8%
10.0%
better than others. They have
80% 9.8% 10.2% higher returns for the same level
85% 10.9% 10.4%
90% 12.1% 10.6%
of risk or less.
95% 13.2% 10.8%
100% 14.3% 11.0%
Two-Security Portfolios with Various
Correlations

return
100%
= -1.0 stocks

= 1.0
100%
= 0.2
bonds

Portfolio Risk/Return Two
Securities: Correlation Effects
Relationship depends on correlation
coefficient
-1.0 < < +1.0
The smaller the correlation, the greater the
risk reduction potential
If= +1.0, no risk reduction is possible
The Efficient Set for Many
Securities

return

Individual Assets

P
Consider a world with many risky assets; we can still identify the
opportunity set of risk-return combinations of various portfolios.
The Efficient Set for Many
Securities

return minimum
variance
portfolio

Individual Assets

Given the opportunity set we can identify the

minimum variance portfolio.
The Efficient Set for Many
Securities

return
o nt i er
r
nt f
cie
effi
minimum
variance
portfolio

Individual Assets

P
The section of the opportunity set above the minimum
variance portfolio is the efficient frontier.
Optimal Risky Portfolio with a Risk-
Free Asset

return
100%
stocks

rf
100%
bonds

In addition to stocks and bonds, consider a world that
also has risk-free securities like T-bills
 Riskless Borrowing and
Lending
L

return
CM 100%
stocks
Balanced
fund

rf
100%
bonds

Now investors can allocate their money across
the T-bills and a balanced mutual fund
 The Capital Market Line
Assumptions:
Rational Investors:
More return is preferred to less.
Less risk is preferred to more.
Homogeneous expectations
Riskless borrowing and lending.

P2 (wF F )2 (wA A )2 2(wF F )(wA A )FA P wA A

Riskless Borrowing and
Lending

return
L
CM efficient frontier

rf

P
With a risk-free asset available and the efficient frontier
identified, we choose the capital allocation line with the steepest
slope
Market Equilibrium

return
L
CM efficient frontier

rf

P
With the capital allocation line identified, all investors choose a point
along the linesome combination of the risk-free asset and the
market portfolio M. In a world with homogeneous expectations, M is
the same for all investors.
The Separation Property

return
L
CM efficient frontier

rf

P
The Separation Property states that the market portfolio, M, is
the same for all investorsthey can separate their risk
aversion from their choice of the market portfolio.
The Separation Property

return
L
CM efficient frontier

rf

P
Investor risk aversion is revealed in their choice of where to stay
along the capital allocation linenot in their choice of the line.
Market Equilibrium

return
CM 100%
stocks
Balanced
fund

rf
100%
bonds

Just where the investor chooses along the Capital Market Line
depends on his risk tolerance. The big point though is that all
investors have the same CML.
Market Equilibrium

return
CM 100%
stocks
Optimal
Risky
Porfolio

rf
100%
bonds

All investors have the same CML because they all have
the same optimal risky portfolio given the risk-free rate.
The Separation Property

return
CM 100%
stocks
Optimal
Risky
Porfolio

rf
100%
bonds

The separation property implies that portfolio choice can
be separated into two tasks: (1) determine the optimal
risky portfolio, and (2) selecting a point on the CML.
Optimal Risky Portfolio with a
Risk-Free Asset
L 0 CML 1

return
CM 100%
stocks

1 First Second Optimal

r f Optimal Risky Portfolio
0 Risky
r f Portfolio
100%
bonds

The optimal risky portfolio depends on the
risk-free rate as well as the risky assets.
Expected versus Unexpected
Returns
Realized returns are generally not equal to
expected returns
There is the expected component and the
unexpected component
At any point in time, the unexpected return can be
either positive or negative
Over time, the average of the unexpected
component is zero
Returns

Total Return = expected return + unexpected

return
Unexpected return = systematic portion +
unsystematic portion
Therefore, total return can be expressed as
follows:
Total Return = expected return + systematic
portion + unsystematic portion
Total Risk

Total risk = systematic risk + unsystematic

risk
The standard deviation of returns is a
measure of total risk
For well diversified portfolios, unsystematic
risk is very small
Consequently, the total risk for a diversified
portfolio is essentially equivalent to the
systematic risk
Portfolio Risk as a Function of the
Number of Stocks in the Portfolio
In a large portfolio the variance terms are effectively
diversified away, but the covariance terms are not.

Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n
Thus diversification can eliminate some, but not all of the
risk of individual securities.
Definition of Risk When Investors
Hold the Market Portfolio
The best measure of the risk of a security in a
large portfolio is the beta ()of the security.
Beta measures the responsiveness of a
security to movements in the market portfolio.

Cov ( Ri , RM )
i
( RM )
2
Total versus Systematic Risk

Consider the following information:

Standard Deviation Beta
Security C 20% 1.25
Security K 30% 0.95
Which security has more total risk?
Which security has more systematic risk?
Which security should have the higher
expected return?
Estimating with
regression

Security Returns
i ne
c L
i
r ist
c te
ara
Ch Slope = i
Return on
market %

Ri = i + iRm + ei
Beta

Reuters
Yahoo
The Formula for Beta

Cov( Ri , RM )
i
( RM )
2

Your estimate of beta will depend upon your choice of a

proxy for the market portfolio.
Beta of a Portfolio

Stock Amount Portfolio Beta

Invested weights
IBM $6,000 50% 0.90 0.450
GM $4,000 33% 1.10 0.367
Walmart $2,000 17% 1.30 0.217
Portfolio $12,000 100% 1.03

The beta of a portfolio is a weighted average of the

betas of the stocks in the portfolio.
Mutual Fund Betas
Relationship of Risk to
Reward
The fundamental conclusion is that the ratio of
the risk premium to beta is the same for every
asset.
In other words, the reward-to-risk ratio is constant and
equal to:

E ( Ri ) RF
Re ward / Risk
i
Market Equilibrium

In equilibrium, all assets and portfolios must

have the same reward-to-risk ratio and they
all must equal the reward-to-risk ratio for the
market

E ( RA ) R f E ( RM ) R f

A M
Relationship between Risk and
Expected Return (CAPM)
Expected Return on the Market:
R M RF Market Risk Premium
Expected return on an individual security:

R i RF i ( R M RF )

Market Risk Premium

This applies to individual securities held within well-diversified
portfolios.
Expected Return on an
Individual Security
This formula is called the Capital Asset Pricing Model
(CAPM)

R i RF i ( R M RF )
Expected
Risk- Beta of the Market risk
return on = +
free rate security premium
a security

Assume i = 0, then the expected return is RF.

Assume i = 1, then R i R M
Relationship Between Risk &
Expected Return
Expected return R i RF i ( R M RF )

RM
RF

1.0
The slope of the security market line is equal to the market risk
premium; i.e., the reward for bearing an average amount of
systematic risk.
Relationship Between Risk &
Expected Return

Expected
return
13.5%

i 1.5 3%
RF 3%
1.5
R M 10%
R i 3% 1.5 (10% 3%) 13.5%
Total versus Systematic Risk

Consider the following information:

Standard Deviation Beta
Security C 20% 1.25
Security K 30% 0.95
Which security has more total risk?
Which security has more systematic risk?
Which security should have the higher
expected return?
Summary and Conclusions
This chapter sets forth the principles of modern portfolio
theory.
The expected return and variance on a portfolio of two
securities A and B are given by
E (rP ) wA E (rA ) wB E (rB )
P2 (wA A )2 (wB B )2 2(wB B )(wA A ) AB
By varying wA, one can trace out the efficient set of portfolios. We
graphed the efficient set for the two-asset case as a curve, pointing out
that the degree of curvature reflects the diversification effect: the lower
the correlation between the two securities, the greater the diversification.
The same general shape holds in a world of many assets.
Summary and Conclusions
The efficient set of risky assets can be combined with
riskless borrowing and lending. In this case, a rational
investor will always choose to hold the portfolio of risky
securities represented by the market portfolio.

return
L
Then with CM efficient frontier
borrowing or
lending, the M
investor selects a
point along the rf
CML.

P
Summary and Conclusions
The contribution of a security to the risk of a well-
diversified portfolio is proportional to the covariance of
the security's return with the markets return. This
contribution is called the beta.
Cov ( Ri , RM )
i
2 ( RM )
The CAPM states that the expected return on a security is
positively related to the securitys beta:

R i RF i ( R M RF )
Expected (Ex-ante) Return,
Variance and Covariance
Expected Return: E(R) = (ps x Rs)

Variance: 2 = {ps x [Rs - E(R)]2}

Standard Deviation =

Covariance: AB = {ps x [Rs,A - E(RA)] x [Rs,B -

E(RB)]}

Correlation Coefficient: AB = AB / (A B)
Risk and Return Example

State Prob. T-Bills IBM HM XYZ Market

Port.
Recession 0.05 8.0% (22.0%) 28.0% 10.0% (13.0%)
Below Avg. 0.20 8.0 (2.0) 14.7 (10.0) 1.0
Average 0.50 8.0 20.0 0.0 7.0 15.0
Above Avg. 0.20 8.0 35.0 (10.0) 45.0 29.0
Boom 0.05 8.0 50.0 (20.0) 30.0 43.0
E(R)=
=
Expected Return and Risk of
IBM
E(RIBM)= 0.05*(-22)+0.20*(-2)
+0.50*(20)+0.20*(35)+0.05*(50) = 18%

IBM2 = 0.05*(-22-18)2+0.20*(-2-18)2
+0.50*(20-18)2+0.20*(35-18)2
+0.05*(5018)2 = 271

IBM =16.5%
Covariance and Correlation

COV IBM&XYZ = 0.05*(-22-18)(10-12.5)+

0.20*(-2-18)(-10-12.5)+0.50*(20-18)(7-12.5)+
0.20*(35-18)(45-12.5)+0.05*(50-18)(30-12.5)
=194

Correlation = 194/(16.5)(18.5)=.6355
Risk and Return for Portfolios (2
assets)
Expected Return of a Portfolio:

E(Rp) = XAE(R)A + XB E(R)B

Variance of a Portfolio:

p2 = XA2A2 + XB2B2 + 2 XA XBAB