Asset Pricing

Principles
Chapter 9
Charles P. Jones, Investments: Principles and Concepts,
Eleventh Edition, John Wiley & Sons

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Capital Asset Pricing
Model
Focus on the equilibrium relationship
between the risk and expected return on
risky assets
Builds on Markowitz portfolio theory
Each investor is assumed to diversify his or

her portfolio according to the Markowitz

model

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CAPM Assumptions
All investors:
Use the same
information to
generate an efficient No transaction costs,
frontier
no personal income
Have the same one-
period time horizon
taxes, no inflation
Can borrow or lend No single investor
money at the risk-free can affect the price
rate of return of a stock
Capital markets are
in equilibrium
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Borrowing and Lending
Possibilities
Risk free assets
Certain-to-be-earned expected return and a
variance of return of zero
No correlation with risky assets
Usually proxied by a Treasury security
Amount to be received at maturity is free of default
risk, known with certainty
Adding a risk-free asset extends and
changes the efficient frontier

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Risk-Free Lending

L
Riskless assets can
be combined with
B
any portfolio in the
E(R) T efficient set AB
Z X Z implies lending
RF Set of portfolios on
A line RF to T
dominates all
portfolios below it
Risk
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Impact of Risk-Free
Lending
If wRF placed in a risk-free asset
Expected portfolio return
E(R p ) w RF RF ( 1-w RF )E(R X )

Risk of the portfolio

p ( 1-w RF ) X

Expected return and risk of the portfolio

with lending is a weighted average

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Borrowing Possibilities
Investor no longer restricted to own wealth
Interest paid on borrowed money

Higher returns sought to cover expense

Assume borrowing at RF
Risk will increase as the amount of
borrowing increases
Financial leverage

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The New Efficient Set
Risk-free investing and borrowing creates a
new set of expected return-risk possibilities
Addition of risk-free asset results in

A change in the efficient set from an arc to a

straight line tangent to the feasible set without
the riskless asset
Chosen portfolio depends on investors risk-return
preferences

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Portfolio Choice
The more conservative the investor the
more is placed in risk-free lending and the
less borrowing
The more aggressive the investor the less is

placed in risk-free lending and the more

borrowing
Most aggressive investors would use leverage to
invest more in portfolio T

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Market Portfolio
Most important implication of the CAPM
All investors hold the same optimal portfolio of
risky assets
The optimal portfolio is at the highest point of
tangency between RF and the efficient frontier
The portfolio of all risky assets is the optimal risky
portfolio
Called the market portfolio

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Characteristics of the Market
Portfolio
All risky assets must be in portfolio, so it is
completely diversified
Includes only systematic risk
All securities included in proportion to their
market value
Unobservable but proxied by S&P 500
Contains worldwide assets

Financial and real assets

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Capital Market Line

M
Line from RF to L is
E(RM) capital market line
(CML)
x x = risk premium
=E(RM) - RF
RF
y y =risk =M
Slope =x/y
M =[E(RM) - RF]/M
Risk y-intercept = RF
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The Separation Theorem
Investors use their preferences (reflected
in an indifference curve) to determine
their optimal portfolio
Separation Theorem:

The investment decision, which risky portfolio

to hold, is separate from the financing decision
Allocation between risk-free asset and risky
portfolio separate from choice of risky
portfolio, T

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Separation Theorem
All investors
Invest in the same portfolio
Attain any point on the straight line RF-T-L by by
either borrowing or lending at the rate RF,
depending on their preferences
Risky portfolios are not tailored to each
individuals taste

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Capital Market Line
Slope of the CML is the market price of risk
for efficient portfolios, or the equilibrium
price of risk in the market
Relationship between risk and expected

return for portfolio P (Equation for CML):

E(RM ) RF
E(R p ) RF p
M

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Security Market Line
CML Equation only applies to markets in
equilibrium and efficient portfolios
The Security Market Line depicts the

tradeoff between risk and expected return

for individual securities
Under CAPM, all investors hold the market

portfolio
How does an individual security contribute to the
risk of the market portfolio?

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Security Market Line
A securitys contribution to the risk of the
market portfolio is based on beta
Equation for expected return for an

individual stock

E(Ri ) RF i E(RM ) RF

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Security Market Line

SM
E(R) L Beta = 1.0 implies
as risky as market
A
kM B
Securities A and B
are more risky than
C
kRF the market
Beta >1.0
Security C is less

0 0.5 1.0 1.5 2.0 risky than the

BetaM market
Beta <1.0
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Security Market Line
Beta measures systematic risk
Measures relative risk compared to the market
portfolio of all stocks
Volatility different than market
All securities should lie on the SML
The expected return on the security should be
only that return needed to compensate for
systematic risk

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CAPMs Expected
Return-Beta Relationship
Required rate of return on an asset (ki) is
composed of
risk-free rate (RF)
risk premium (i [ E(RM) - RF ])
Market risk premium adjusted for specific security
ki = RF +i [ E(RM) - RF ]
The greater the systematic risk, the greater the
required return

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Estimating the SML
Treasury Bill rate used to estimate RF
Expected market return unobservable

Estimated using past market returns and taking

an expected value
Estimating individual security betas difficult
Only company-specific factor in CAPM
Requires asset-specific forecast

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Estimating Beta
Market model
Relates the return on each stock to the return on
the market, assuming a linear relationship
Ri = i + i RM +ei
Characteristic line
Line fit to total returns for a security relative to
total returns for the market index

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How Accurate Are Beta
Estimates?
Betas change with a companys situation
Not stationary over time
Estimating a future beta
May differ from the historical beta
RM represents the total of all marketable
assets in the economy
Approximated with a stock market index
Approximates return on all common stocks

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How Accurate Are Beta
Estimates?
No one correct number of observations and
time periods for calculating beta
The regression calculations of the true

and from the characteristic line are

subject to estimation error
Portfolio betas more reliable than individual

security betas

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Arbitrage Pricing Theory
Based on the Law of One Price
Two otherwise identical assets cannot sell at
different prices
Equilibrium prices adjust to eliminate all arbitrage
opportunities
Unlike CAPM, APT does not assume
single-period investment horizon, absence of
personal taxes, riskless borrowing or lending,
mean-variance decisions

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Factors
APT assumes returns generated by a factor
model
Factor Characteristics

Each risk must have a pervasive influence on

stock returns
Risk factors must influence expected return and
have nonzero prices
Risk factors must be unpredictable to the market

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APT Model

Most important are the deviations of the

factors from their expected values
The expected return-risk relationship for the

APT can be described as:

E(Ri) =RF +bi1 (risk premium for factor 1)
+bi2 (risk premium for factor 2) +
+bin (risk premium for factor n)

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Problems with APT
Factors are not well specified ex ante
To implement the APT model, need the factors
that account for the differences among security
returns
CAPM identifies market portfolio as single factor
Neither CAPM or APT has been proven
superior
Both rely on unobservable expectations

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Coeficient Beta : Contoh
i = Cov(rirM
1) / M
Expected Return : E(ri)= RF + i [E(rM)- RF]
= Ri E(r)

Sto Return Covariance antara

ck Realisasi Saham i dgn index pasar
A 17 Cov (rArM) 0.972 %
B 14 Cov (rBrM) 0.648 %
C 15 Cov (rCrM) 1.215 %
D 16 Cov (rDrM) 0.6075 %
 Contoh 2
Diketahui expected return dari index pasar
adalah 11%. Suku bunga SBI sebesar 8%. Data
untuk tiga saham A, B dan C adalah sebagai
berikut :
Saham A Saham B Saham C

Harga periode Rp 1,350 Rp 5,500 Rp 1,400

sekarang (Pt)
Harga periode lalu (Pt- Rp 1,000 Rp 5,000 Rp 1,000
1)

Beta saham () 0,8 1,2 1,5

Return Realisasi : Ri= (Pt - Pt-1) / Pt-1

Expected Return : E(ri)= RF + i [E(rM)- RF]
= Ri E(r)
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