9-1

THE CAPITAL ASSET

PRICING MODEL
CHAPTER 9
9-2
Outline of the Chapter
CAPM
What is CAPM?
Assumptions of CAPM
Market Portfolio in CAPM
CAPM equation
Security Market Line
Extensions of CAPM
The Zero-Beta Model
Labor Income
Multiperiod Model
A Consumption Based CAPM
Liquidity included CAPM
Differences and similarities between CAPM and the
Index Model (will be discussed later)
9-3
The Capital Asset Pricing Model
CAPM is a cornerstone of modern financial theory
CAPM shows the relationship between risk of an
asset and its expected return
Developed by Sharpe (1964), Lintner(1965) and
Mossin (1966)
The CAPM provides
A benchmark rate of return for evaluating possible
investments
i.e. Whether the expected return of the stock is more or
less than its fair return given its risk
Help to make an educated guess as to the expected
return on assets that have not yet been traded in the
marketplace
i.e. Pricing an IPO
9-4
The Capital Asset Pricing Model (Continued)
Assumptions
Assumptions are employed to guarantee the
similarity between different people with the
exception of initial wealth and risk aversion.
1.Individual investors are price takers
Individuals act as though security prices are
unaffected by their own trades. The wealth of a
single investor is so small compared to the total
wealth in the economy
9-5
The Capital Asset Pricing Model (Continued)
2. Single period investment horizon
Investor plan for one identical holding period
They ignore everything that might happen after
the end of the single period horizon
3. Investments are limited to publicly traded
financial assets, such as stocks and bonds, and
to risk-free borrowing or lending arrangements
Rules out investment in nontraded assets such
as human capital
Investor may borrow or lend any amount at a
fixed, risk-free rate
9-6
The Capital Asset Pricing Model (Continued)
4. Investors pay no taxes on returns and no
transaction costs (commissions and service
charges) on trades in securities
Information is costless and available to all
investors
5. Investors are rational mean-variance optimizers
All investors use the Markowitz portfolio
selection model (optimal P on efficient frontier)
9-7
The Capital Asset Pricing Model (Continued)
6. There are homogeneous expectations
All investors analyse the securities in the same
way and share the same economic view of the
world
The input list of Markowitz model is same for all
investors. Given a set of security prices and the
risk-free rate, all investor use the same expected
returns and covariance matrix of security returns
to generate the efficient frontier and the unique
optimal risky portfolio
9-8
The Capital Asset Pricing Model (Continued)
Resulting equilibrium conditions:
All investors will choose to hold a portfolio of risky
assets in proportions that duplicate
representation of the assets in the market
portfolio, M, which includes all traded assets
The proportion of each stock (asset) in the market
portfolio=market value of the stock (price per share
multiplied by the number of shares
outstanding)/total market value of all stocks
The best attainable capital allocation line is the
CML, line from the risk-free rate and tangent to M
All investors hold M, they only differ in the amount
invested in risk-free asset
9-9
The Capital Asset Pricing Model (Continued)
What is the market portfolio?
When we add the portfolios of all individual investors,
lending and borrowing will cancel out (each lender has
a matching borrower), and the value of the aggregate
risk portfolio will equal the entire wealth of the
economy. This aggregate risk portfolio which is equal to
the entire wealth of the economy is called the market
portfolio, M
The proportion of each stock (all assets in the
economy) in this portfolio equals the market value of
the stock divided by the sum of the market values of all
stocks
The CAPM implies that as individuals attempt to
optimize their personal portfolios, they arrive at the
same portfolio, with weights on each asset equal to
those of the market portfolio
9-10
The Capital Asset Pricing Model (Continued)
If all investors use identical
Markowitz analysis applied to
the same universe of
securities for the same time
horizon and use the same
input list, they all must arrive at
the same consumption of the
optimal risky portfolio, the
portfolio on the efficient frontier
identified by the tangency line
from T-bills to the frontier
Thus, the optimal risky
portfolio of investors mimics
the market portfolio in a
smaller scale
9-11
The Capital Asset Pricing Model (Continued)
All assets should be included in the portfolio.
Assume the stock of company X is not included in
the optimal risky portfolio. Since the demand for
the stock of company X is 0 its price decreases.
As its price decreases it becomes more attractive.
At the end its price decreased to a level and make
the stocks of company X attractive enough to be
included in the optimal risky portfolio
All investors hold the same identical risky
portfolio, which has to be M, the market portfolio
and M should include all assets.
9-12
The Capital Asset Pricing Model (Continued)
Mutual fund theorem: Assuming that all investors
choose to hold a market index mutual fund,
portfolio selection can be divided into two:
A technical problem: creation of mutual funds
by professional managers
A personal problem: depends on an investors
risk aversion, allocation of the complete
portfolio between the mutual fund and the
risk-free assets
9-13
The Capital Asset Pricing Model (Continued)
In the CAPM the appropriate risk premium on an
asset will be determined by its contribution to the
risk of investors overall portfolios.
Suppose there is a market portfolio and stocks of
GE in this market portfolio
n
1 k
GE k k
n
1 k
k k GE M GE
n
1 k
k k M
r r Cov w
r w r Cov r r Cov
r w r
) , (
) , ( ) , (
9-14
The Capital Asset Pricing Model (Continued)
The contribution of the GE to the variance of the
market portfolio:
w
GE
Cov(r
GE
,r
M
)
The contribution of the GE to the risk premium
of the market portfolio:
w
GE
[E(r
GE
)-r
f
]
The reward-to-risk ratio for investments in GE:
( ) ( )
GE's contribution to risk premium
GE's contribution to variance ( , ) ( , )
GE GE f GE f
GE GE M GE M
w E r r E r r
w Cov r r Cov r r
9-15
The Capital Asset Pricing Model (Continued)
Market price of risk: The extra return that
investors demand to bear portfolio risk
2
( )
Market risk premium
Market variance
M f
M
E r r
In the equilibrium, all investments should
offer the same reward-to-risk ratio.
2
M
f M
M GE
f GE
r r E
r r Cov
r r E ) (
) , (
) (
9-16
The Capital Asset Pricing Model (Continued)
Then the risk premium for the GE can be
determined by the equation:
2
( , )
( ) ( )
GE M
GE f M f
M
Cov r r
E r r E r r
The ratio Cov(r
GE
,r
M
)/
2
M
measures the
contribution of the GE stock to the variance of the
market portfolio.
This ratio is called beta ()
9-17
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
The Capital Asset Pricing Model (Continued)
9-18
The Capital Asset Pricing Model (Continued)
Risk premium on an individual security is a
function of its covariance with the market
Risk premium on individual assets will be
proportional to the risk premium on the
market portfolio, M, and the beta coefficient of
the security relative to the market portfolio.
Beta measures the extent to which returns on
the stock and the market move together

i
=Cov(r
i
,r
M
)/
2
M
E(r
i
)-r
f
=[Cov(r
i
,r
j
)/
2
M
][E(r
M
)-r
f
]=
i
[E(r
M
)-r
f
]
9-19
The Capital Asset Pricing Model (Continued)
Then, the expected return-beta relationship
gives us the CAPM
] ) ( [ ) (
f M GE f GE
r r E r r E
This formula can be used to measure the
appropriate risk premium for the individual
securities in an environment where everyone
holds the same identical risky portfolio.
9-20
The Capital Asset Pricing Model (Continued)
What about the portfolios?
If the expected return-beta relationship holds for any
individual asset, it must hold for any combination of
assets. Thus the CAPM becomes:
n
1 k
k k P
n
1 k
k k P
f M P f P
w
r E w r E
where
r r E r r E
) ( ) (
,
] ) ( [ ) (
9-21
The Capital Asset Pricing Model (Continued)
This equation also holds for the market portfolio.
1
r r Cov
where
r r E r r E
2
M
2
M
2
M
M M
M
f M M f M
) , (
,
] ) ( [ ) (
Beta greater than 1 are named as aggressive. High-beta
stocks entails above-average sensitivity to market volatility.
In an efficient market security prices already reflect public
information about a firms prospects thus only the risk of
the company (beta in the CAPM) should affect its expected
return.
Thus investors receive high expected returns only if they
are willing to bear risk.
9-22
The Capital Asset Pricing Model (Continued)
Beta in the CAPM shows the risk of the
security because beta is proportional to
the risk that the security contributes to the
optimal risky portfolio.
The expected return-beta relationship is
known as security market line as can be
seen on a graph in Figure 9.2.
9-23
The Capital Asset Pricing Model (Continued)
] ) ( [ ) (
f M i f i
r r E r r E
Slope of the SML is the risk
premium of the market
portfolio.
9-24
The Capital Asset Pricing Model (Continued)
Comparison between CML and SML
CML graphs the risk premium of efficient
portfolios (market portfolio and risk-free assets)
as a function of portfolio standard deviation
The standard deviation is the valid measure of risk for
efficiently diversified portfolios that are candidates for
an investors overall portfolio
SML graphs the individual asset risk premiums as
a function of asset risk.
Beta is the valid measure of risk for individual assets
since it shows the contribution of the asset to the
portfolio variance
SML is valid for both efficient portfolios and individual
assets
9-25
The Capital Asset Pricing Model (Continued)
SML provides a benchmark for the evaluation of
investment performance
Given the risk (beta) what should be the rate of
return on the investment?
Fairly priced assets should lie on the SML.
If an asset is underpriced then it will be plotted
above the SML. It provides an expected return in
excess of its fair return.
If an asset is overpriced then it will be plotted
below SML.
9-26
The Capital Asset Pricing Model (Continued)
Alpha () is the difference
between the fair and actually
expected rates of return on a
stock.
9-27
Is the CAPM Practical?
CAPM has two predictions as a model:
The market portfolio is efficient.
The security market line (expected return-beta
relationship) accurately describes the risk-return
trade-off, which is alpha values are zero.
However testing these predicitions is not that
easy.
The hypothesized market portfolio is not
observable.
The market portfolio in CAPM includes all risky
assets that can be held by investors.
including bonds, real estate, foreign assets,
privately held businesses and human capital
9-28
Is the CAPM Practical? (Continued)
In statistical tests, CAPM fails. The data
rejects the hypothesis that alpha values are 0.
The reasons of the failure
Data problems
Validity of the market proxy
Statistical methods
9-29
Extensions of the CAPM
The Zero-Beta Model
Merton and Roll (1972) state that:
Any portfolio that is a combination of two frontier
portfolios is itself on the efficient frontier.
The expected return of any assets can be
expressed as an exact linear function of the
expected return on any two efficient-frontier
portfolios P and Q
9-30
Extensions of the CAPM (Continued)
Every portfolio on the efficient frontier, except the
global mimum-variance portfolio, has a companion
portfolio on the inefficient half of the frontier with
which it is uncorrelated. The companion portfolio is
referred to as zero-beta portfolio of the efficient
portfolio since they are uncorrelated.
Fisher (1972) shows that if there is a restriction on
borrowing and /or lending in the risk-free asset then
some investors might choose portfolios on the
efficient frontier but not the market portfolio and
their zero-beta portfolio component.
9-31
Extensions of the CAPM (Continued)
Labor Income and Nontraded Assets
Unfortunately all risky asset classes are not
traded as assumed by CAPM.
Labor income (human capital)
Mayers (1972) tries to incorporate the labor
income into the CAPM model and drives the
equilibrium expected return-beta equation for an
economy in which individuals are endowed with
the labor income of varying size relative to their
nonlabor capital
9-32
Extensions of the CAPM (Continued)
A Multiperiod Model and Hedge Portfolios
Merton (1992) relaxes the single period
assumption in CAPM.
In his model the investors have a lifetime
consumption/investment plan and adapt their
consumption/investment decisions to current
wealth and planned retirement age.
Thus investors have multiperiod to think of, not
just a single one.
9-33
Extensions of the CAPM (Continued)
When uncertainty about portfolio returns are the
only source of risk and investment opportunities
remain unchanged through time then ICAPM
(intertemporal capital asset pricing model) predicts
the same expected return-beta relationship as
CAPM for single-period.
However if there are other sources of risk
Changes in future risk-free rate, expected returns and
the risk of the market portfolio (vairance in its return).
Changes in the parameters describing investment
opportunities.
9-34
Extensions of the CAPM (Continued)
Changes in the prices of the consumption goods
that can be purchased with any amount of
wealth such as inflation risk.
Then investors will change their
consumption/investment plans by taking into
account these changes.
9-35
Extensions of the CAPM (Continued)
A Consumption-Based CAPM
Rubinstein (1976), Lucas (1978) and Breeden
(1979) suggests a model that investors must
allocate current wealth between todays
consumption and investment for the future.
In a lifetime comsumption plan, the investor must
in each period balance the allocation of current
wealth between todays consumption and the
savings and investment that will support future
consumption.
Investors will value additional income more highly
during difficult economic times (when
consumption opportunities are scarce)
9-36
Extensions of the CAPM (Continued)
An asset will be viewed risker if it has a positive
covariance with consumption growth. Its payoff is
higher when the consumption is already high.
So, equilibrium risk premiums for this asset will be
greater.
9-37
Liquidity and the CAPM
Liquidity: The ease and speed with which an
asset can be sold at fair market value.
Cost of engaging in the transaction:
i.e. The bid-ask spread
Price impact: the adverse movement in price one
would encounter when attempting to execute a
large trade.
Immediacy: the ability to sell the asset quickly
without reverting to fire-sale prices.
9-38
Liquidity and the CAPM (Continued)
The security dealers contribute to overall market
liquidity by adding new shares to their inventory
or selling shares from their inventory.
The fee they earn for supplying this liquidity is
the bid-ask spread.
The spread, cost of transaction in a security, is a
component (measure) of liquidity.
Spread is lower in more liquid assets.
Note: the spread also gives information related to
the asymmetric information.
9-39
Liquidity and the CAPM (Continued)
What is asymmetric information?
The potential for one trader to have private
information about the value of the security that is
not known to the trading partner.
Asymmetric information affects the markets
Buyers who suspects asymmetric information
wants to decreae the prices since they suspect
that there is something wrong which they do not
know.
In extreme cases trading may cease altogether
e.g. Akerlofs lemons
9-40
Liquidity and the CAPM (Continued)
Why do investors trade securities?
Noninformational motvies
These sorts of trading are not motivated by the
private information related to the traded security.
They are executed to raise cash (for liquidity
purposes) for another investment or rebalancing
the portfolio.
9-41
Liquidity and the CAPM (Continued)
Informational motives
These transactions are motivated by the private
information known only to seller or buyer
(asymmetric information)
These kinds of trading widens the spread.
Since one of the parties in an advantegeous
situation in this kind of trading traders posting a
limit order wants to protect themselves against the
possibility that other party knows more. Thus they
increase the limit-ask prices and decrease limit-bid
orders.
They ask for a higher price to sell and offer a lower
price to buy.
9-42
Liquidity and the CAPM (Continued)
Illiquidity: can be measured by the discount from
fair market value a seller must accept if the
asset is to be sold quickly.
The discount increases with the number of
transaction for a given spread.
Investors who trade less frequently will be less
affected from the high trading costs. The
reduction in the rate of return due to trading costs
is lower the longer the security is held.
In equilibrium investors with long holding periods
will hold more of the illiquid securities, while
short-horizon investors will prefer liquid securities.
9-43
Liquidity and the CAPM (Continued)
What about unexpected changes in the liquidity?
Investors demand compensation for the liquidity
risk.
Depending on overall conditions in the securities
market the bid-ask spreads and ability to sell the
security changes.
If asset liquidity fails then an investor will ask for
more price discount beyond that required for the
expected cost of illiquidity.
Thus, Acharya and Pedersen (2005) incorporates
this unexpected changes in the liquidity into the
CAPM.
9-44
The CAPM and the Index Model
Since the CAPM depends on expectations in
order to make it testable we need more
assumptions.
The connection from expected to the realized
returns is the Single-index model.
In excess return form
2
M
M i
i
2
M i M i
f i i
i M i i i
R R Cov
R R Cov
r r R
where
e R R
) , (
) , (
,
9-45
The CAPM and the Index Model (Continued)
Thus,

INDEX
=
CAPM
We replace the theoretical (unobservable)
market portfolio of the CAPM with the
observable market index.
9-46
The CAPM and the Index Model (Continued)
] ) ( [ ) (
) (
] ) ( [ ) (
) (
:
f M i i f i
i f M i i f i
f M i f i
i f M i f i
r r E r r E
e r r r r
Index Single
r r E r r E
e r r r r
CAPM
Thus, CAPM predicts that
i
should be 0 for all assets.
The alpha of a stock is its expected return in excess of (or
below) the fair expected return as predicted by CAPM.
If the stock is fairly priced then its alpha must be 0.
9-47
The CAPM and the Index Model (Continued)
CAPM relates expected return to risk
Expected risk premium on any asset is
proportional to the expected risk premium on the
market portfolio with beta as the proportionality
constant.
It has problems however:
Expectations are unobservable
Market portfolio includes every risky asset and
unobservable as well
9-48
The CAPM and the Index Model (Continued)
To overcome these problems
Single-Factor Model
Assumes one economic factor, F shows the
only common influence on the security
retuns.
Security returns beyond F are affected from
independent, firm-specific factors.
Single-Index Model
Assumes F can be replaced by a broad-
based index of securities that can proxy
CAPMs theoretical market portfolio.