An Introduction to

Asset Pricing Models

Mokhalidah O. Mulok November 7, 2020
Graduate Studies, CBAA
MSU-IIT
 After you read this chapter, you should be
able to answer the following questions:
•How does capital market theory extend Markowitz portfolio theory
with the addition of a risk-free asset?

•What are the other critical assumptions underlying capital market

theory?

• What is the capital market line (CML), and how does it enhance our
understanding of the relationship between risk and expected return?

•What is the market portfolio, and what role does it play in the
investment process implied by the CML?
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 After you read this chapter, you should be
able to answer the following questions:
•Under what conditions does the CML recommend the use of leverage
in forming an investor’s preferred strategy?

•What is the difference between systematic and unsystematic risk, and

how does that relate to the concept of diversification?

•How does the capital asset pricing model (CAPM) extend the results of
capital market theory?

•What special role does beta play in the CAPM, and how do investors
calculate a security’s characteristic line in practice?
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 After you read this chapter, you should be
able to answer the following questions:
•What is the security market line (SML), and what are the similarities
and differences between the SML and CML?
•How can the SML be used to evaluate whether securities are properly
priced?
•What assumptions are necessary for the CAPM, and what impact does
relaxing those assumptions have?
•What do the various empirical tests of the CAPM allow us to conclude?
•Does the selection of a proxy for the market portfolio matter?

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 Recap on the previous topic
Markowitz Portfolio Theory

•A portfolio model that derives the expected rate of return for a

portfolio of assets and a measure of expected risk, which is the
standard deviation of expected rates of return.

•Optimum portfolio is a combination of investments, each having

desirable individual risk-return characteristics that also fit together
based on their correlations.

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 Capital Market Theory
•An expansion of the portfolio theory which allows the pricing or
valuation of all risky assets through a model called Capital Asset Pricing
Model (CAPM)

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 Background for Capital Market Theory:
Assumptions
1. All investors are Markowitz-efficient in that they seek to invest in tangent
points on the efficient frontier.
2. Investors can borrow or lend any amount of money at the risk-free rate of
return (RFR).
3. All investors have homogeneous expectations;
4. All investors have the same one-period time horizon, such as one month or
one year.
5. All investments are infinitely divisible
6. There are no taxes or transaction costs involved in buying or selling assets.
7. There is no inflation or any change in interest rates, or inflation is fully
anticipated
8. Capital markets are in equilibrium.
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 Background for Capital Market Theory:
Development
The major factor that allowed Markowitz portfolio theory to develop
into capital market theory is the concept of a risk-free asset

• asset with zero variance

• zero correlation with all other risky assets
• provide the risk-free rate of return (RFR)
• will lie on the vertical axis of a portfolio graph.

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 Developing the Capital Market Line
Covariance with a Risk-Free Asset

•Because the returns for the risk-free asset are certain (σRF = 0), Ri
= E(Ri) during all periods, this means that the covariance of the
risk-free asset with any risky asset or portfolio of assets will
always equal zero.

•Similarly, the correlation between any risky asset i, and the risk-
free asset, RF, would be zero since rRF;i = CovRF;i/σRFσj
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 Developing the Capital Market Line (CML)
Combining a Risk-Free Asset with a Risky Portfolio, M
•Expected Return

•Standard Deviation
Expected Variance for a two-asset portfolio:
Substitute RF asset for security 1, and risky asset (M) for security 2:

Since σRF = 0 therefore

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 Developing the Capital Market Line (CML)
The Capital Market Line
•Risk-return relationship between E(Rport) and σport

Equation 8-1:

•The risk-return relationship shown above holds for every

combination of the risk-free asset with any collection of risky assets.

•However, when the risky portfolio, M, is the market portfolio

containing all risky assets held anywhere in the marketplace, this
linear relationship is called the Capital Market Line.

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 Developing the Capital Market Line (CML)
Risk-Return Possibilities with Leverage
•An investor may want to attain a higher expected return than is
available at Point M in exchange for accepting higher risk.

Alternatives:
1. Invest in one of the risky asset portfolios on the Markowitz
frontier beyond Point M such as the portfolio at Point D
2. Add leverage to the portfolio by borrowing money at the risk-free
rate and investing the proceeds in the risky asset portfolio at
Point M; this is depicted as Point E

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 Developing the Capital Market Line (CML)

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 Risk, Diversification, and the Market Portfolio
•Market Portfolio

-Because portfolio M lies at the point of tangency, it has the highest

portfolio possiblity line.
-Everybody will want to invest in Portfolio M and borrow or lend to be
somewhere on the CML.
-Therefore, this portfolio must include ALL RISKY ASSETS.
- Since market portfolio contains all risky assets, it is a completely
diversified portfolio

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 Risk, Diversification, and the Market Portfolio
•Completely Diversified Portfolio - This means that all risk unique to each
asset in the portfolio is diversified away.

•Unsystematic risk – unique risk offset by the unique variability of all other
holdings in the portfolio

•Systematic risk - variability in all risky assets caused by macroeconomic

variables, remains in Portfolio M.
-Measured by standard deviation of returns to the market portfolio.
-Examples of macroeconomic factors: interest rates, inflation, recessions

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 How to Measure Diversification
• All portfolios on the CML are perfectly positively correlated, so all
portfolios on the CML are perfectly correlated with the completely
diversified market Portfolio M.

• A completely diversified portfolio would have a correlation with the

market portfolio of +1.00.

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 Diversification and the Elimination of
Unsystematic Risk
• As you add securities, the average covariance for the portfolio
declines.

• Observe what happens as you increase the sample size of the

portfolio by adding securities that have some positive correlation

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 Diversification and the Elimination of
Unsystematic Risk

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 The Capital Asset Pricing Model (CAPM)
• A model based on the proposition that any stock’s required rate of
return is equal to the risk free rate of return plus a risk premium that
reflects only the risk remaining after diversification

• Redefines the relevant measure of risk from total volatility to just the
nondiversifiable portion of that total volatility (i.e., systematic risk).

• Beta coefficient is a measure of a security’s systematic or relevant risk

in a portfolio context. Shows the extent to which a given stock’s returns
move up and down with the stock market

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 The CAPM Formula

Expected Rate Overall Market Risk Premium

Of Return Risk-free Rate of Return Beta Coefficient
shows the extent to which a - The additional return over the
given stock’s returns move up risk-free rate needed to
and down with the stock compensate investors for
market. Beta thus measures assuming an average amount of
market risk. risk.

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 The Security Market Line
•Illustrates the CAPM.
•Shows the trade-off between risk and expected return as a straight line
intersecting the vertical axis (i.e., zero-risk point) at the risk-free rate

CML SML
●
Measures risk by standard deviation ●
Focus is on investment’s systematic
(i.e. total risk) risk (beta)
●
Can be applied to portfolio that are ●
Can be applied to any individual
fully diversified. asset or collection of assets

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 The Security Market Line

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 Determining the Expected Rate of Return for
a Risky Asset
Assume that we expect the economy’s
RFR to be 5 percent (0.05) and the
expected return on the market portfolio
(E(RM)) to be 9 percent (0.09). This
implies a market risk premium of 4
percent (0.04).

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 Determining the Expected Rate of Return for
a Risky Asset

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 Identifying Undervalued and Overvalued
Assets

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 Identifying Undervalued and Overvalued
Assets

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 Impact of the Time Interval to the Beta
• Shorter weekly interval caused a larger beta for large firms and a
smaller beta for small firms.

•The impact of time interval increases as the firm size decline.

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 The Effect of the Market Proxy

•Standard & Poor’s 500 Composite Index is most often used as a proxy
for the market portfolio because the stocks in this index encompass a
large proportion of the total market value of U.S. stocks and it is a
value-weighted series, which is consistent with the theoretical market
series.

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 Relaxing The Assumptions
 Differential Borrowing and Lending Rates
- One of the first assumptions of the CAPM was that investors could
borrow and lend any amount of money at the risk-free rate.
- For example, when T-bills are yielding 4 percent, most individuals
would have to pay about 6 or 7 percent to borrow at a bank.
 Zero-Beta Model
- If the market portfolio (M) is mean-variance efficient (i.e., it has the
lowest risk for a given level of return among the attainable set of
portfolios), an alternative model, derived by Black (1972), does not
require a risk-free asset.

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 Relaxing The Assumptions
 Transaction Costs
- The CAPM assumes that there are no transaction costs, so investors
will buy or sell mispriced securities until they plot on the SML
- Therefore, securities will plot very close to the SML, but not exactly
on it
 Heterogeneous Expectations and Planning Periods
- If all investors had different expectations about risk and return,
each would have a unique CML or SML,
- If you are using a one-year planning period, your CML and SML
could differ from someone with a one-month planning period

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 Relaxing The Assumptions
 Taxes
- The expected returns in the CAPM are pretax returns.
- Could cause major differences in the CML and SML among
investors.

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 Additional Empirical Tests of the CAPM
 Stability of Beta
- the risk measure was not stable for individual stocks, but was stable
for portfolios of stocks
- the larger the portfolio (e.g., over 50 stocks) and the longer the
period (over 26 weeks), the more stable the beta estimate.
- betas tended to regress toward the mean.

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 Additional Empirical Tests of the CAPM
 Relationship between Systematic Risk and Return
- Effect of skewness on Relationship
High-beta stocks have high-positive skewness, which implied that
investors prefer stocks with high-positive skewness that provide an
opportunity for very large returns.
- Effect of size, P/E and Leverage
The relationship of Size and P/E with returns are inverse.

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 Additional Empirical Tests of the CAPM
 Relationship between Systematic Risk and Return
- Effect of Book-to-Market Value
There’s positive relation between book-to-market equity ratio
(BE/ME) and average returns also persists when the other variables
are included

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 Summary of CAPM Risk-Return Empirical
Results
•Most of the early evidence regarding the relationship between returns
and systematic risk of portfolios supported the CAPM

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 The Market Portfolio: Theory Versus Practice
•There is a controversy over the market portfolio. Hence, proxies are
used.
•There is no unanimity about which proxy to use.
•An incorrect market proxy will affect both the beta risk measures ang
the position and slope of the SML that is use to evaluate the portfolio
performance.

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