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Lecture 4 - CAPM Proof

This document derives the Capital Asset Pricing Model (CAPM) mathematically. It shows that a portfolio's expected return depends on its exposure to systematic market risk as measured by its beta. Specifically: 1) It considers a portfolio with weights equal to the market portfolio except for one stock. The portfolio's Sharpe ratio is maximized when the stock's weight equals the market weight. 2) Taking derivatives and evaluating at the market weights yields an expression relating individual stock expected returns to their covariance with the market. 3) Substituting this into the portfolio return equation derives the CAPM formula, where expected return is equal to the risk-free rate plus the stock's beta times the market risk

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Shashank Gupta
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402 views5 pages

Lecture 4 - CAPM Proof

This document derives the Capital Asset Pricing Model (CAPM) mathematically. It shows that a portfolio's expected return depends on its exposure to systematic market risk as measured by its beta. Specifically: 1) It considers a portfolio with weights equal to the market portfolio except for one stock. The portfolio's Sharpe ratio is maximized when the stock's weight equals the market weight. 2) Taking derivatives and evaluating at the market weights yields an expression relating individual stock expected returns to their covariance with the market. 3) Substituting this into the portfolio return equation derives the CAPM formula, where expected return is equal to the risk-free rate plus the stock's beta times the market risk

Uploaded by

Shashank Gupta
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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FM473

Portfolio Theory and CAPM


1
We now mathematically derive CAPM based on the fact that
the market portfolio coincides with the tangency portfolio,
which lies on the steepest line that passes though the risk
free asset (i.e., the line with the highest Sharpe ratio).

Denote the proportion of wealth in riskless asset by w
f
, and
the proportion of wealth in asset i by w
i
,
The return on a portfolio with expected value (after
substituting out w
f
) and volatility
P
is given by:



.
, ) (


= =
= =
o o = o
+ = + =
N
i
N
j
ij j i j i P
n
i
f i i f
n
i
i i f f P
w w
r r w r r w r w r
1 1
2
1 1
. ... 1
1
= + + +
N f
w w w
P
r
(1)
CAPM: Derivation
FM473
Portfolio Theory and CAPM
2
Consider now a portfolio P with stock weights equal to the
weights of market portfolio, except for stock k:

Suppose, we fix all portfolio weights except for weight w
k
and
consider the Sharpe ratio as a function of w
k
.
We know, that the market portfolio has highest possible
Sharpe ratio. Hence, Sharpe ratio of portfolio P will be
maximized when
Therefore, the following first order condition should hold:



P f P
r r o / ) (
. ,..., , , ,...,
M
N N
M
k k
M
k k
M
k k
M
w w w w w w w w w w = = = = =
+ + 1 1 1 1 1 1
.
M
k k
w w =
| |
.
/ ) (
0 =
o
=
M
k k
w w
k
P f P
dw
r r d
(2)
CAPM: Derivation
FM473
Portfolio Theory and CAPM
3
Using chain and product rules we obtain:


From this equation and (2), evaluating the expressions at
, we obtain:


where all derivatives are evaluated at


| |
.
) ( / ) (
k
P
P
f P
k
f P
P k
P f P
dw
d r r
dw
r r d
dw
r r d o
o

o
=
o
2
1
,
) (
k
P
M
f M
k
f P
dw
d r r
dw
r r d o
o

.
M
k k
w w =
(3)
M
k k
w w =
CAPM: Derivation
FM473
Portfolio Theory and CAPM
4
Taking into account (1), computing the derivatives with
respect to w
k
and evaluating them at we obtain:


The last equality holds because:

Hence, the derivative evaluated at is given by:
.
) , cov(
,
) (
M
M k
k
P
P k
P
f k
k
f P
r r
dw
d
dw
d
r r
dw
r r d
o
=
o
o
=
o
=

2
2
1
M
k k
w w =
. ) , cov(
,
k
N
k i i
i k
M
i k k k P
w r r w w w without terms 2
1
2 2 2
+ + o = o

= =
( )
). , cov( ) ... , cov(
) , cov( ... ) , cov( ... ) , cov(
M k N
M
N
M
k
N k
M
N k k
M
k k
M
k
P
r r r w r w r
r r w r r w r r w
dw
d
2 2
2
1 1
1 1
2
= + + =
+ + + + =
o
M
k k
w w =
(4)
CAPM: Derivation
FM473
Portfolio Theory and CAPM
5
Substituting (4) into (3), we can show, for any asset k



This formula can be rewritten in terms of beta:


Hence, expected returns depend on the exposures to the
market risk measured by beta.
Expected returns are not determined by individual stock
return volatilities, as unique risk can be diversified away.
), (
) , cov(
f M
M
M k
f k
r r
r r
r r
o
=
2
beta,
k

( ).
k f k M f
r r r r | =
stock excess
return
market excess
return
CAPM: Derivation

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