F INANCE AND F INANCIAL M ANAGEMENT

L ECTURE F OUR –T HE CAPM

Dr Sofia Gueorgieva

Imperial College Business School

2024 – 2025
 Alpha à performance?
identify investment skills?

Beta à (relative) risk?

https://edition.cnn.com/cnn-underscored/money/alpha-vs-beta-investing
By Rocco Pendola, Paul Curcio, & David Tony, CNN Underscored Money,
19 January 2024
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 O UTLINE

1. The Market Portfolio and the Capital Market Line (CML)

2. Deriving the CAPM
3. The Securities Market Line (SML)
4. Applications of CAPM
5. CAPM in practice

Reading: Textbook Chapter 9

Practice Problems 9.1. - 9.23.

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 1. T HE C APM

The Capital Asset Pricing Model (CAPM) allows us to talk about systematic risk.
CAPM theory answers questions like
- how do we measure the riskiness of a security in a portfolio?
- what is the expected return of a security?
- what are 𝛼 and 𝛽?
- how do we determine a company’s cost of capital (the discount rate in
calculations that check the viability of business projects, aka NPV)?
The CAPM is also known as the Sharpe/Lintner model, after the two researchers
who independently developed the model.
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1. T HE CAL VERSUS THE CML

borrow

lend

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 1. T HE M ARKET P ORTFOLIO

• Since all rational investors will hold the same risky portfolio (in combination
with the risk-free asset), this portfolio must be the portfolio of all risky assets.
• This portfolio is the market portfolio in equilibrium.
• It includes not just stocks but all assets - such as risky bonds, real estate,
commodities etc. We cannot observe its return, so we use a proxy for it such
as a stock market index containing a large number of securities.
- Market value of an asset = Price x Number of shares (bonds etc.)
- the weight of each asset in the market portfolio equals
"#$%&' )#*+& ,- #..&' !
Weight i = 𝑤! = "#$%&' )#*+& ,- #** #..&'.

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 1. T HE C APITAL M ARKET L INE

• Individuals choose a portfolio on the Capital Market Line (CML).

• It connects the risk-free asset with the market portfolio.
• Risk-averse investors hold more of the risk-free asset.
• Risk-tolerant (less risk-averse) investors hold more of the market portfolio.

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 2. D ERIVING THE C APM

Exercise 1:
Using the formula for the variance of a portfolio, show how the risk of the
market portfolio depends on each asset.

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 2. R ISK -R EWARD R ATIO ACROSS A SSETS

The reward-to-risk ratio must be the same for all assets and portfolios.

𝐸 𝑅! − 𝑅- 𝐸[𝑅" ] − 𝑅-
=
𝐶𝑜𝑣 (𝑅" , 𝑅! ) 𝑉𝑎𝑟 (𝑅" ) BETA!

𝐶𝑜𝑣 (𝑅" , 𝑅! )
𝐸 𝑅! = 𝐸 𝑅" − 𝑅- + 𝑅-
𝑉𝑎𝑟 (𝑅" )

=
The CAPM equation 𝐸 𝑅! = 𝑅- + 𝛽! 𝐸 𝑅" − 𝑅-

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3. C APITAL M ARKET L INE VERSUS S ECURITIES M ARKET L INE

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 3. W HAT IS B ETA ?

!"# (&! ,&" )

Beta 𝛽 = is a measure of the systematic risk of an asset.
)*+ (&! )

• CAPM says only systematic risk is priced and that there exists a positive linear
relationship between the expected return of an asset and its beta.
• Idiosyncratic risk can be and is diversified away, and so is not priced.
• Intuition: Investors want remuneration (return) for bearing the
systematic risk, not total risk.
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 3.R ETURNS AS PER C APM

Exercise 2:
𝛽//0 = 0.42 𝛽112/ = 1.20

Expected return on the market (S&P 500) is E[RM] = 14.5%

Risk-free rate of interest Rf = 5.5%

What are the expected returns on Eli Lilly and Apple?

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 4.A PPLICATION OF C APM (1)

• Analysts compare the returns of stocks against their fair expected return from
the CAPM.
• Stocks that have returns above what CAPM prescribes (high-alpha stocks) are
under-valued and should be bought.
Alpha is the difference between the actual return and what CAPM states:

𝛼 = 𝐸 𝑅! − 𝑅" + 𝛽! 𝐸 𝑅# − 𝑅"

• A stock’s alpha is the unexpected deviation from the fair return.

• 𝛼 is the excess performance above the CAPM return.
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 4.P ERFORMANCE M EASURES

• Consider three mutual funds.

• All three are characterised by E[R] = 15% and var[R] = 20%.

• Their betas differ: 0.2, 0.8 and 1.4.

• Which fund does best (is most skilled)?

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4.P ERFORMANCE R ESULTS

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 4. A PPLICATION OF C APM (2)

• Capital Budgeting Decisions: should firms undertake risky projects?

• Need to calculate Net Present Value (NPV) to determine that.

• Decision rule: only undertake projects with NPV > 0.

• Compare the decision with the IRR (yield) approach.

• How do you discount cashflows?

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 4. A N NPV E XAMPLE

Exercise 3
A project costs £1300 today. If undertaken, it is expected to generate cashflows
of £400 in 3 years, £800 in 4 years, and £1200 in 5 years.
𝛽23 = 1.75 Rf = 5% E[RM] = 13%
Should you invest in the project? What if 𝛽23 = 0.5?

Cost of capital
The opportunity cost of an investment is the same as the CAPM-implied return!

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 5. C APM IN P RACTICE

• CAPM relies on a theoretical market of all possible assets.

• An index model uses an actual stock index to proxy this theoretical market.

• CAPM makes forward-looking predictions. Index models use historical data.

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 5. T HE I NDEX M ODEL

• The CAPM states: 𝐸 𝑅! − 𝑅- = 𝛽! 𝐸 𝑅" − 𝑅-

• The Index Model states: 𝑅! − 𝑅- = 𝛼! + 𝛽! 𝑅" − 𝑅- + ∈!

• 𝛼 is the abnormal return while ∈ is firm-specific risk.

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 5. C APM IN P RACTICE - MSFT

• Estimate the index model using Microsoft data

• Use daily historical data from 2000-2022

• The market index is S&P

• Risk free rate is the treasury bill

• Use a linear regression to estimate the index model

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5. T HE DATA AT A G LANCE

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 5. L INEAR R EGRESSION

• Regression line
𝑅! − 𝑅- = 𝛼! + 𝛽! 𝑅" − 𝑅- + ∈!
𝑅! − 𝑅- = 0.0003 + 1.0748 𝑅" − 𝑅- + ∈!

• 𝑅4 = 0.4786

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 5. I NTERPRETATION

• The slope of the line is Microsoft’s beta

• If the Market return goes up by 1%, Microsoft’s goes up by 1.07%.

• The intercept is Microsoft’s alpha.

• Microsoft outperformed the CAPM by 0.0003% per day.

• R2 is a measure of the fit: 48% of the variation in Microsoft is systematic – the

rest is firm-specific.

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5. C APM AND G OLD

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5. S OME B ETAS

1.56 in 2024, now 1.53

0.35 in 2024, now 0.45

0.59 in 2024, now 0.61
0.97 in 2024, now 0.89

0.45 in 2024, now 0.35

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 5. C APM AS THE I NDEX M ODEL

• The CAPM equation can be written as the index model:

𝑅! = 𝑅- + 𝛽! 𝑅" − 𝑅- + 𝜖!

• Assume 𝐸 ∈! = 0, 𝐶𝑜𝑣 ∈! , 𝑅" = 0

• Hence,
𝑉𝑎𝑟 𝑅! = 𝑉𝑎𝑟 𝑅" + 𝛽! 𝑅# − 𝑅" + 𝜖!
𝜎!$ = 𝑉𝑎𝑟 𝛽! 𝑅# − 𝑅" + 𝜖!
= 𝛽!$ 𝜎#
$
+ 𝜎.!$

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 5. A PPLYING THAT

Exercise 4:

Regal Cruises stock has a volatility of 76% and a beta of 2.5. The market
portfolio has an expected return of 15% and a volatility of 0.20. The risk-free
rate is 5%.

What is the expected return of the stock of Regal Cruises?

What is the proportion of Regal Cruises’ variance which is diversified away in

the market portfolio?

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 5. P ORTFOLIO B ETA

• If you have a portfolio consisting of two assets L and S with weights wL and wS,
then the beta of your portfolio will be the weighted average of the beta of the
constituent assets.
𝑐𝑜𝑣 (𝑅# , 𝑤& 𝑅& + 𝑤' 𝑅' )
𝛽% =
𝑉𝑎𝑟 (𝑅# )
𝑐𝑜𝑣 (𝑅# , 𝑅& ) 𝑐𝑜𝑣 (𝑅# , 𝑅' )
= 𝑤& + 𝑤'
𝑉𝑎𝑟 (𝑅# ) 𝑉𝑎𝑟 (𝑅# )
= 𝑤& 𝛽& + 𝑤' 𝛽'

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 5. P ORTFOLIO E XAMPLE

Exercise 5:

Defensive stocks have 𝛽5 = 0.6. High-growth stocks have 𝛽6 = 1.4. How can
you construct a portfolio of the two types such that there is no market risk?

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 5. M ULTIPLE FACTORS A FFECTING THE R ETURN

What if there are multiple sources of risk?

𝐸 𝑅! − 𝑅- = 𝛽!7 𝑆7 + … +𝛽!8 𝑆8 + ∈!

where SK is the risk premium of factor k.

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 TAKEAWAYS

• CAPM allows us to determine how much stocks should return.

• CAPM can capture systemic risk with 𝛽 and relative performance with ⍺.

• Risk and return are positively correlated in the CAPM.

• Can estimate the CAPM with the Index Model.

• Can use the CAPM to calculate Cost of Capital.

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 D EFINITIONS
Alpha 𝜶 = 𝑬 𝑹𝒊 − [𝑹𝒇 + 𝜷 (𝑬 𝑹𝑴 − 𝑹𝒇) ]
'()(+! ,+" )
Beta 𝛽 =
)-.(+! )

Market portfolio = the combination of risky assets all agents hold

CML = capital market line = the line that connects the Market Portfolio to the
risk-free asset
SML (securities market line) = the line showing returns as a function of betas.
CAPM: 𝐸 𝑅/ = 𝑅0 + 𝛽/ 𝐸 𝑅1 − 𝑅0
Cost of capital = opportunity cost of investment = same as CAPM return!
NPV (net present value) = the sum of the present value of all cashflows
IRR (internal rate of return) = same as the yield from Lecture 2
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 S OLUTION TO E XERCISE 1

𝑉𝑎𝑟 𝑅1 = 𝑣𝑎𝑟 4 𝑤/ 𝑅/
4 4 4 4

= 4 4 𝑤/ 𝑤5 𝐶𝑜𝑣(𝑅/ 𝑅5 ) = 4 𝑤/ 4 𝑤5 𝐶𝑜𝑣(𝑅/ , 𝑅5 )
/23 523 /23 523

4 4 4

= 4 𝑤/ 4 𝐶𝑜𝑣 𝑅/ , 𝑤5 𝑅5 = 4 𝑤/ 𝐶𝑜𝑣 𝑅/, , 𝑅1

/23 523 /23

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 S OLUTION TO E XERCISE 2

For Eli Lilly

E[RLLY] = Rf + 𝛽667 (E[RM] – Rf)
= 0.045 + 0.32 * (0.145 – 0.045) = 0.045 + 0.42 * 0.10 =
= 0.045 + 0.042 = 0.087 = 8.7%

E[RAAPL] = Rf + 𝛽8896 (E[RM] – Rf)

= 0.045 + 1.20 * (0.145 – 0.045) = 0.045 + 1.20 * 0.10 =
= 0.045 + 0.12 = 0.165 = 16.50%

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 S OLUTION TO E XERCISE 3

With 𝛽!" = 1.75, the cost of capital equals:

𝐸 𝑅!" = 𝑅# + 𝛽!" 𝐸 𝑅$ − 𝑅# = 0.05 + 1.75 ∗ 0.13 − 0.05 = 0.19
Use 19% to discount the cash flows:
400 800 1200
𝑁𝑃𝑉 = −1300 + + +
1.19 % 1.19 & 1.19 '
= −1300 + 237.37 + 398.94 + 502.86 = −1300 + 1139.16 = −160.84 < 0 è Reject!
With 𝛽!" = 0.5, the cost of capital equals:
𝐸 𝑅!" = 𝑅# + 𝛽!" 𝐸 𝑅$ − 𝑅# = 0.05 + 0.5 ∗ 0.13 − 0.05 = 0.09
Use 9% to discount the cash flows:
400 800 1200
𝑁𝑃𝑉 = −1300 + + +
1.09 % 1.09 & 1.09 '
= −1300 + 308.87 + 566.74 + 779.92 = −1300 + 1655.53 = +355.53 > 0 è Accept!
IRR = 15.35%. IRR Rule: accept if IRR > E[RPR] and vice versa.
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 S OLUTION TO E XERCISE 4

𝐸 𝑅+' = 𝑅0 + 𝛽+' 𝐸[𝑅1 − 𝑅0 ) = 0.05 + 2.5 ∗ (0.15 − 0.05) = 30%

: : : :
𝜎+' = 𝛽+' 𝜎1 + 𝜎C+'
:
0.76: = 2.5: 0.2: + 𝜎C+'
:
0.5776 = 0.25 + 𝜎C+'
:
𝜎C+' = 0.3276
This means that 0.3276 / 0.5776 = 56.72% of the variance is idiosyncratic.
56.72% of the volatility of this security can be diversified away by holding a
diversified portfolio. The other 43.28% is systematic risk that cannot be
diversified away. The investors can get rid of all of the idiosyncratic risk by
holding a diversified portfolio.
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 S OLUTION TO E XERCISE 5

𝛽9 = 𝑤; 𝛽; + 𝑤< 𝛽< = 𝑤; 𝛽9 + (1 − 𝑤; ) 𝛽<

0 = 0.6 𝑤; + 1.4(1 − 𝑤; ) = 1.4 − 0.8 𝑤;
0.8 𝑤; = 1.4
𝑤; = 1.75
𝑤< = −0.75

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