Universidad Carlos III 9/2/2010

Topic 6- The Capital Asset Pricing Model (CAPM)

Outline

Topic 6 1. THE CAPITAL ASSET PRICING MODEL

The Capital Asset Pricing 1. Assumptions and foundations of the model
Model (CAPM) 2. The CML (Capital Market Line)
3. The SML (Security Market Line)
Copyright of Spanish version from David Moreno
Translation into English by Francisco Romero
4. The Beta (β)
Universidad Carlos III
5. The Beta (β) of a portfolio
Financial Economics

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1- Assumptions and foundations of the model 1- Assumptions and foundations of the model

The CAPM (Capital Asset Pricing Model) is fundamental The CAPM is a theoretical model and therefore it is based on
for modern finance, even though it was developed 50 years assumptions:
ago. a) It is a static model; economic agents only focus on what happens one
period ahead (1 quarter ahead, 1 year ahead etc.)
b) Perfect competition in financial markets. There are many investors (each
The CAPM was developed by William Sharpe (1962). He with a different utility function and initial wealth). Furthermore, investors
received the Nobel Prize.. are price takers.
c) Risky financial assets are perfectly divisible and supply is exogenous.
d) The same interest rate applies to lending and borrowing.
It is a model that works when financial markets are e) There are no transaction costs and taxes.
equilibrium.
f) Investors optimize according to Markowitz theory (i.e. care about mean-
 Therefore, Supply=Demand variance trade-off).
g) Investors share the same information, therefore, their risk and return
expectations for each asset are identical.
The CAPM builds on the Markowitz mean-variance model .
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2- The CML (Capital Market Line) 2- The CML (Capital Market Line)

Given that investors share the same information and follow the THE “MARKET PORTFOLIO” COINCIDES WITH THE
mean-variance model, all choose the tangency portfolio T as te TANGENCY PORTFOLIO:
optimal portfolio of risky assets.  This is easily shown given our previous assumptions.
But they differ in the percentage of his/her wealth allocated to  What is the “market portfolio”?
the risk-free asset and to portfolio T.  The portfolio that includes all risky assets available.
E[Rp]
 In equilibrium when we add together everyone’s holdings of
CML portfolio T, we must have every share in every company in the
market. So T is also called the market portfolio, M.
 The weight of asset “j” in the market portfolio is equivalent to
Cartera
CarteraÓptima
tangente
Tangent portfolio the total value of asset “j” in the economy, divided by the total
value of all risky assets in the economy.
Cartera óptima
Rf Investor’s optimal portfolio
del inversor
P* represents equilibrium
Value of asset " j" n P*
Wj = = j j prices, as S =D.
Value of the market portfolio N
Riesgo
Risk
 ni Pi*
i =1
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2- The CML (Capital Market Line) 2- The CML (Capital Market Line)

If every investor holds the tangency portfolio as his risky asset This is why we can replace the tangency portfolio with the
(obtained from the mean-variance model) and the CAPM is an market portfolio in the mean-variance graph:
equilibrium model (i.e. Excess Supply =0), then the weight of
an asset in the tangent portfolio is equal to the weight of this E[Rp]
asset in the market portfolio. Frontera Eficiente
Efficient Frontier

CAL
CML
EXAMPLE:: suppose that the weight of TEF shares in the
EXAMPLE
tangent portfolio is 23%. This means that all agents have 23%
E[Rc]
of their wealth invested in TEF shares. Therefore, if the
market portfolio is the sum of all portfolios from all economic Cartera
Market Óptima
Portfolio “M”
agents, TEF shares will also represent a 23% of the market. Rf

The same applies for the remaining assets.

Riesgo
Risk

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3- The SML (Security Market Line) 3- The SML (Security Market Line)

Under the CAPM agents hold diversified portfolios, hence Therefore:

they demand a risk premium which depends on the systematic
risk of each asset (and not on specific risk). E [ri ] = rf + β i ( E [rM ] − r f )
E[ Ri ] = β i ( E[rM ] − r f )
The systematic risk wdepends on β, therefore, investors
demand a return that will be a function of β.
Risk premiums are represented by capital letters:
 rM-rf=RM→ Market Risk Premium
The fundamental CAPM equation relates an asset’s risk
 E(ri)-rf=Ri → Asset “i” Risk Premium
premium to:
 The expected market risk premium
 The asset’s systematic risk (its beta)

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3- The SML (Security Market Line) 3- The SML (Security Market Line)

Example: Under the CAPM assumptions, determine

Example: CAPM derivation:
AMADEUS’ shares expected return taking into account that Assume a portfolio p with proportion “a” of wealth in asset
next year expected market return is 11.5%, one-year t-bills offer i and porportion “(1-a)” in the market portfolio.
a return of 3.5%, and AMADEUS’ β is 1.8.
1. Is the expected return on shares of AMADEUS higher
than the expected return of the market?
market? The risk and return of portfolio p is:
E[ rp ] = (1 − a ) E [rM ] + aE [ri ]
2. Determine the expected return on shares of AmadeusAmadeus..
σ r = [(1 - a) 2 σ M2 + a 2σ i2 + 2a(1 - a)σ i ,M ]
1/ 2
p
Answers::
Answers

Different portfolios are generated by changing the weight

“a”. These portfolios are represented by the curve I-I’.

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3- The SML (Security Market Line) 3- The SML (Security Market Line)
For a=0.
(I-I’) is tangent to the ∂E[ rp ]
CML in M (where a=0) = E[ri ] − E[rM ]
∂a a = 0

∂σ (rp ) σ − σ M2
= [σ M2 ] [− 2σ M2 + 2σ i , M ] = i ,M
1 −1/ 2

At point M, the slope ∂a a = 0 2 σM

of I-I’ and the slope
of the CML are the
same. The slope of I-I’ at M is:
∂E[rp ]
∂a E[ri ] − E[rM ]
=
∂σ (rp ) σ i , M − σ M2
To calculate the slope at M: ∂a a =0 σM
∂E[rp ]
∂a
= E[ri ] − E[rM ] Equating the slopes of I-I’ and of the CML at point M (as done
previously): E[ r ] − r E[ r ] − E[ r ]
∂σ ( rp ) 1
∂a
[
= (1 − a) 2 σ M
2
2
+ a 2σ i2 + 2a(1 − a)σ i ,M ] [2aσ
−1/ 2 2
M − 2σ M2 + 2aσ i2 + 2σ i ,M − 4aσ i ,M ]
M

σM
f
= i M
σ i , M − σ M2
σM
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3- The SML (Security Market Line) 3- The SML (Security Market Line)

Then: The relationship between expected return and systematic risk is

σ i ,M − σ M2 Given that:
represented by the SML.
E[ ri ] − E[ rM ] = ( E[rM ] − rf )
σ M2 σ i,M Can an asset be represented outside
βi = the SML?
σ M2 E[ri]

E[ ri ] = E[ rM ] + ( E[rM ] − rf )(β i − 1)  Only temporarily, not in equilibrium.

SML
 If an asset is not on the SML, the
E[ ri ] = rf + β i ( E[ rM ] − r f )
E[rM]
CAPM establishes that investors will bring
it back to equilibrium.
This is the CAPM basic expression
expression..
rf  If an asset has a Beta =1, and its
 We can represent graphically the expected return required (in expected return is higher than the
equilibrium) for holding a asset depending on its systematic BM=1 market’s return, all agents will buy
Bi
this asset, causing price to increase,
risk SML (Security Market Line) and then reducing its return until it is
Slope of SML = market risk premium located on the SML.
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4- The Beta 4- The Beta

The BETA:
BETA It can be calculated by a
 ri
 As we have already seen: regression of the asset’s
Total Risk Specific Risk Systematic Risk excess return on the
= + market excess return.
Variance BETA

ri ,t = α + βrm ,t + ε i ,t rM

The Beta measures an asset’s contribution to the risk of a

well diversified portfolio (or market portfolio).  Then,
Cov( ri , rm )
The Beta shows the sensitivity of an asset’s excess return to β=
changes in the market return. σ r2m
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4- The Beta 4- The Beta

Example Determine the beta and the expected return of shares of

Example: We can differentiate between shares according to their Betas:
TELEFON, given that the covariance between the returns of this
shares and the IGBM is 0.099, the standard deviation of returns on Beta < 1 Defensive stock
the shares is 17%, and the standard deviation of returns on the
market index (IGBM) is 24%. In addition, te return on a one-year T- Beta = 1 Neutral stock
bill is 4.5%, and the expected market risk premium is 8%.
Beta > 1 Aggressive stock

Answer::
Answer

Questions:
 What is the market beta or the beta of the market portfolio?
 What is the beta of the risk-free asset?

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5- The portfolio Beta 5- The portfolio Beta

Example:: Suppose that an investment fund holds a portfolio with three risky
Example
THE PORTFOLIO BETA: assets, with the following characteristics:
 Asset 1: β= 0.05, and portfolio weight 20%.
 Given that the Beta measures non-diversifiable risk, the
 Asset 2: β= 1.02, and portfolio weight 35%.
portfolio beta is the portfolio-weighted average of the  The returns of asset 3 have a covariance with the returns of the market of
betas of its individual securities. 0.0399.
Considering that the standard deviation of returns of the market portfolio is
19%, compute the β of this portfolio.

With N assets Answer::

Answer
With 2 assets N
β p = w1β1 + w2 β 2 β p =  wi β i
i =1

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Readings USEFUL WEBSITES

Brealey, R.A. and Myers, S.C. (2003). Principles of Corporate BANCO DE ESPAÑA:
Finance. McGraw Hill
 Chapter 8
 http://www.bde.es

DIRECICIÓN GENERAL DEL TESORO:

Suárez Suárez, Andrés S. (2005). Decisiones óptimas de inversión y
financiación en la empresa. Ediciones Piramide.  http://www.tesoro.es
 Chapters 32, 33 and 34.
MERCADO AIAF:
Brigham E.F. and Daves, P. R. (2002). International Financial  http://www.aiaf.es
Mangement. South-Western.
 Chapters 2 and 3.
BOLSA DE MADRID
 http://www.bolsamadrid.es
Grinblatt, M. and Titman, S. (2002). Financial Markets and Corporate
Strategy. McGraw Hill INVERCO
 Chapter 5.
 http://www.inverco.es
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