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04 CAPM Review

- The document summarizes equations related to the Capital Asset Pricing Model (CAPM) including equations for the two-asset minimum-risk portfolio, the N-asset optimal portfolio, and the CAPM equation. It also discusses the efficient frontier, security market line, and provides an example with exercises. - The example considers a market with two stocks and calculates the minimum-risk portfolio, optimal portfolio given a trade-off parameter, market portfolio, mean return and variance of the market portfolio, betas for each stock, risk-free rate, and expected unit price of one stock in one year according to CAPM.

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Noorma Megawati
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41 views16 pages

04 CAPM Review

- The document summarizes equations related to the Capital Asset Pricing Model (CAPM) including equations for the two-asset minimum-risk portfolio, the N-asset optimal portfolio, and the CAPM equation. It also discusses the efficient frontier, security market line, and provides an example with exercises. - The example considers a market with two stocks and calculates the minimum-risk portfolio, optimal portfolio given a trade-off parameter, market portfolio, mean return and variance of the market portfolio, betas for each stock, risk-free rate, and expected unit price of one stock in one year according to CAPM.

Uploaded by

Noorma Megawati
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Capital Asset Pricing Model (CAPM)

Part 3: Review & Exercises


Summary of Equations
 Two-Asset minimum-risk portfolio
2
∗
𝜎𝜎𝐵𝐵 − 𝜌𝜌𝜎𝜎𝐴𝐴 𝜎𝜎𝐵𝐵
𝑤𝑤𝐴𝐴 = 2 2, 𝑤𝑤𝐵𝐵∗ = 1 − 𝑤𝑤𝐴𝐴∗
𝜎𝜎𝐴𝐴 − 2𝜌𝜌𝜎𝜎𝐴𝐴 𝜎𝜎𝐵𝐵 + 𝜎𝜎𝐵𝐵

 𝑁𝑁-Asset optimal portfolio


Σ −1 𝑒𝑒 −1
𝑒𝑒 𝑇𝑇 Σ −1 𝜇𝜇 −1
𝑤𝑤𝑜𝑜𝑜𝑜𝑜𝑜 = 𝑇𝑇 −1 + 𝜏𝜏 Σ 𝜇𝜇 − 𝑇𝑇 −1 Σ 𝑒𝑒 = 𝑤𝑤𝑚𝑚 + 𝜏𝜏𝑤𝑤𝑧𝑧
𝑒𝑒 Σ 𝑒𝑒 𝑒𝑒 Σ 𝑒𝑒

 The CAPM equation


𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅𝐴𝐴 , 𝑅𝑅𝑀𝑀 𝜎𝜎𝐴𝐴𝑀𝑀
𝜇𝜇𝐴𝐴 = 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝐴𝐴 𝜇𝜇𝑀𝑀 − 𝑟𝑟𝑓𝑓 , 𝛽𝛽𝐴𝐴 = = 2
𝑉𝑉𝑉𝑉𝑟𝑟 𝑅𝑅𝑀𝑀 𝜎𝜎𝑀𝑀
Efficient Frontier
 Efficient portfolios lie on efficient frontier
 Hyperbola in 𝜎𝜎, 𝜇𝜇 -plane if no 𝑟𝑟𝑓𝑓
𝜇𝜇𝑃𝑃
 CML if 𝑟𝑟𝑓𝑓 exists

 The market portfolio lie on both


 The risky efficient frontier 𝜇𝜇𝑀𝑀
 The CML

𝜇𝜇𝑃𝑃 −𝑟𝑟𝑓𝑓
 Sharpe ratio: rf
𝜎𝜎𝑃𝑃
 Same for all portfolios on CML
 Different value for different CALs
σM σP
 What is the EF with 𝑟𝑟𝑓𝑓 but requires 𝑤𝑤 ≥ 0?
Security Market Line (SML)

 The CAPM Equation


𝜇𝜇𝐴𝐴 = 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝐴𝐴 𝜇𝜇𝑀𝑀 − 𝑟𝑟𝑓𝑓 𝜇𝜇 Z
X

 Fairly priced assets lie of the SML


 Above SML  underpriced
Y
 Below SML  overpriced

 The CAPM Structure 𝑟𝑟𝑓𝑓


𝑅𝑅𝐴𝐴 = 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝐴𝐴 𝑅𝑅𝑀𝑀 − 𝑟𝑟𝑓𝑓 + 𝜖𝜖𝐴𝐴 , 𝐸𝐸 𝜖𝜖𝐴𝐴 = 0

 Systematic risk measured by 𝛽𝛽


 “Sensitivity” to market fluctuations
𝛽𝛽

PAGE 4
Example & Exercises
 Consider a financial market with only two stocks as follows
No. of shares Unit price 𝝁𝝁 𝝈𝝈 𝝆𝝆
Stock A 400 $50 8% 12%
0
Stock B 1,000 $80 14% 20%
# shares Unit price 𝝁𝝁 𝝈𝝈 𝝆𝝆

Example & Exercises Stock A 400 $50 8% 12%


𝟎𝟎
Stock B 1,000 $80 14% 20%

 Find the minimum-risk portfolio 𝑃𝑃.

 Calculate 𝜇𝜇𝑃𝑃 & 𝜎𝜎𝑃𝑃 .

𝜇𝜇𝑜𝑜 = 9.59%, 𝜎𝜎𝑜𝑜 = 10.29%


# shares Unit price 𝝁𝝁 𝝈𝝈 𝝆𝝆

Example & Exercises Stock A 400 $50 8% 12%


𝟎𝟎
Stock B 1,000 $80 14% 20%

 Use matrix-vector notation to state 𝜇𝜇, Σ for the risky assets.

 Calculate Σ −1 .
1
0
69.44 0
Σ −1 = 0.0144 =
1 0 25
0
0.04
# shares Unit price 𝝁𝝁 𝝈𝝈 𝝆𝝆

Example & Exercises Stock A 400 $50 8% 12%


𝟎𝟎
Stock B 1,000 $80 14% 20%

 Given trade-off parameter 𝜏𝜏, find the optimal portfolio 𝑤𝑤𝑜𝑜𝑜𝑜𝑜𝑜

0.7353 −1.1029
𝑤𝑤𝑜𝑜𝑜𝑜𝑜𝑜 = 𝑤𝑤𝑚𝑚 + 𝜏𝜏𝑤𝑤𝑧𝑧 = + 𝜏𝜏
0.2647 1.1029

 Identify the minimum-risk portfolio 𝑤𝑤𝑚𝑚 as well as 𝑤𝑤𝑧𝑧


# shares Unit price 𝝁𝝁 𝝈𝝈 𝝆𝝆

Example & Exercises Stock A 400 $50 8% 12%


𝟎𝟎
Stock B 1,000 $80 14% 20%
𝑇𝑇
 Verify that the portfolios 𝑤𝑤𝑚𝑚 & 𝑤𝑤𝑧𝑧 are uncorrelated, 𝑤𝑤𝑚𝑚 Σ𝑤𝑤𝑧𝑧 = 0
# shares Unit price 𝝁𝝁 𝝈𝝈 𝝆𝝆

Example & Exercises Stock A 400 $50 8% 12%


𝟎𝟎
Stock B 1,000 $80 14% 20%

 Verify that the mean return 𝜇𝜇 𝑇𝑇 𝑤𝑤𝑧𝑧 equals to portfolio variance 𝑤𝑤𝑧𝑧𝑇𝑇 Σ𝑤𝑤𝑧𝑧
Example & Exercises
2 1
 Prove that the minimum-risk portfolio 𝑤𝑤𝑚𝑚 has variance 𝜎𝜎𝑚𝑚 =
𝑒𝑒 𝑇𝑇 Σ−1 𝑒𝑒
# shares Unit price 𝝁𝝁 𝝈𝝈 𝝆𝝆

Example & Exercises Stock A 400 $50 8% 12%


𝟎𝟎
Stock B 1,000 $80 14% 20%

 What is the total market value?

V 100,000
 What is the market portfolio?

𝑤𝑤𝑀𝑀 =
0.2 4
0.8

 What are the mean return and variance of the market portfolio?
0 232 0.125 08
Am 0.2 0.08
𝜇𝜇𝑀𝑀 = 12.8%
2
𝜎𝜎𝑀𝑀 = 0.026176
TE
08 O 14 o 212
G 128 12.89
Example & Exercises
 Calculate 𝛽𝛽𝐴𝐴

Tam Cov CRA Rm 𝜎𝜎𝐴𝐴𝑀𝑀 = 0.00288

For Ra 0.2Ra to 8RB 𝜎𝜎𝐴𝐴𝑀𝑀


𝛽𝛽𝐴𝐴 = 2 = 0.11
𝜎𝜎𝑀𝑀
0.2 var RA t
o 8 CovLRA RB

O 2 0.1232
08 o
O 00288
Example & Exercises
 What is the risk-free rate 𝑟𝑟𝑓𝑓 ?

Ma if Ba Mm 7

re Majette
Example & Exercises
 Calculate 𝛽𝛽𝐵𝐵 and use it to find 𝑟𝑟𝑓𝑓

𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅𝐵𝐵 , 𝑅𝑅𝑀𝑀 = 𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅𝐵𝐵 , 0.2𝑅𝑅𝐴𝐴 + 0.8𝑅𝑅𝐵𝐵 = 0.2𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅𝐴𝐴 , 𝑅𝑅𝐵𝐵 + 0.8𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅𝐵𝐵 , 𝑅𝑅𝐵𝐵
𝜎𝜎𝐵𝐵𝑀𝑀 = 0.032
𝛽𝛽𝐵𝐵 = 1.2225

𝜇𝜇𝐵𝐵 − 𝛽𝛽𝐵𝐵 𝜇𝜇𝑀𝑀


𝜇𝜇𝐵𝐵 = 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝐵𝐵 𝜇𝜇𝑀𝑀 − 𝑟𝑟𝑓𝑓 ⇒ 𝑟𝑟𝑓𝑓 = = 7.4%
1 − 𝛽𝛽𝐵𝐵
Example & Exercises
 What is the expected unit price of Stock A in one year according to the CAPM
model?

By definition of %-return (𝜇𝜇𝐴𝐴 ),

𝐸𝐸 𝑆𝑆𝑜𝑜+1 − 𝑆𝑆𝑜𝑜
= 𝜇𝜇𝐴𝐴 = 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝐴𝐴 𝜇𝜇𝑀𝑀 − 𝑟𝑟𝑓𝑓
𝑆𝑆𝑜𝑜
So
𝐸𝐸 𝑆𝑆𝑜𝑜+1 = 𝑆𝑆𝑜𝑜 1 + 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝐴𝐴 𝜇𝜇𝑀𝑀 − 𝑟𝑟𝑓𝑓

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