CHAPTER 9
The Capital Asset Pricing Model
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Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
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Capital Asset Pricing Model
(CAPM)
It is the equilibrium model that underlies all
modern financial theory
Derived using principles of diversification
with simplified assumptions
Markowitz, Sharpe, Lintner and Mossin are
researchers credited with its development
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Assumptions
Individual investors
are price takers
Single-period
investment horizon
Investments are
limited to traded
financial assets
No taxes and
transaction costs
Information is
costless and available
to all investors
Investors are rational
mean-variance
optimizers
There are
homogeneous
expectations
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Resulting Equilibrium Conditions
All investors will hold the same portfolio
for risky assets market portfolio
Market portfolio contains all securities and
the proportion of each security is its
market value as a percentage of total
market value
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Resulting Equilibrium Conditions
Risk premium on the market depends on
the average risk aversion of all market
participants
Risk premium on an individual security
is a function of its covariance with the
market
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Figure 9.1 The Efficient Frontier and
the Capital Market Line
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Market Risk Premium
The risk premium on the market portfolio
will be proportional to its risk and the
degree of risk aversion of the investor:
E (rM ) rf A M2
where M2 is the variance of the market portolio and
A is the average degree of risk aversion across investors
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Return and Risk For Individual
Securities
The risk premium on individual
securities is a function of the individual
securitys contribution to the risk of the
market portfolio.
An individual securitys risk premium is
a function of the covariance of returns
with the assets that make up the market
portfolio.
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GE Example
Covariance of GE return with the
market portfolio:
Cov(rGE , rM ) Cov rGE , wk rk wk Cov (rk , rGE )
k 1
k 1
Therefore, the reward-to-risk ratio for
investments in GE would be:
E (rGE ) rf
GE's contribution to risk premium wGE E (rGE ) rf
GE's contribution to variance
wGE Cov( rGE , rM ) Cov( rGE , rM )
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GE Example
Reward-to-risk ratio for investment in
market portfolio:
Market risk premium E (rM ) rf
Market variance
M2
Reward-to-risk ratios of GE and the
market portfolio should be equal:
E rGE rf
Cov rGE , rM
E rM rf
M2
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GE Example
The risk premium for GE:
COV rGE , rM
E rGE rf
E rM rf
2
M
Restating, we obtain:
E rGE rf GE E rM r f
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Expected Return-Beta
Relationship
CAPM holds for the overall portfolio because:
E (rP ) wk E (rk ) and
k
P wk k
k
This also holds for the market portfolio:
E (rM ) rf M E (rM ) rf
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Figure 9.2 The Security Market
Line
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Figure 9.3 The SML and a PositiveAlpha Stock
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The Index Model and Realized
Returns
To move from expected to realized
returns, use the index model in excess
return form:
Ri i i RM ei
The index model beta coefficient is the
same as the beta of the CAPM expected
return-beta relationship.
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Figure 9.4 Estimates of Individual
Mutual Fund Alphas, 1972-1991
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Is the CAPM Practical?
CAPM is the best model to explain
returns on risky assets. This means:
Without security analysis, is
assumed to be zero.
Positive and negative alphas are
revealed only by superior security
analysis.
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Is the CAPM Practical?
We must use a proxy for the market
portfolio.
CAPM is still considered the best
available description of security
pricing and is widely accepted.
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Econometrics and the Expected
Return-Beta Relationship
Statistical bias is easily introduced.
Miller and Scholes paper
demonstrated how econometric
problems could lead one to reject the
CAPM even if it were perfectly valid.
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Extensions of the CAPM
Zero-Beta Model
Helps to explain positive alphas on
low beta stocks and negative
alphas on high beta stocks
Consideration of labor income and
non-traded assets
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Extensions of the CAPM
Mertons Multiperiod Consumption-based
Model and hedge
CAPM
portfolios
Rubinstein, Lucas,
Incorporation of the
and Breeden
effects of changes in Investors allocate
the real rate of
wealth between
interest and inflation
consumption today
and investment for
the future
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Liquidity and the CAPM
Liquidity: The ease and speed with which
an asset can be sold at fair market value
Illiquidity Premium: Discount from fair
market value the seller must accept to
obtain a quick sale.
Measured partly by bid-asked spread
As trading costs are higher, the
illiquidity discount will be greater.
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Figure 9.5 The Relationship
Between Illiquidity and Average
Returns
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Liquidity Risk
In a financial crisis, liquidity can
unexpectedly dry up.
When liquidity in one stock decreases, it
tends to decrease in other stocks at the
same time.
Investors demand compensation for
liquidity risk
Liquidity betas
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