The Capital Asset Pricing

Model (CAPM)

FIN 411, Prof. Dmitry Orlov

FIN 411: CAPM Prof. Dmitry Orlov 1

 Fundamental Question
n Question: Why do some securities earn higher
average returns than others?

n Answer: Finance theory says because of risk

q But what is risk?
n In the 50s pretty much everyone would have said volatility
q How much extra expected return do we require to
bear extra risk?

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 Fundamental Question
n CAPM answers these questions, and has many
important applications:
q Valuation
n How much is a company worth? Where do required rates of
return come from?
q Is a stock under- or overvalued?
q Mutual fund performance evaluation
q Companys investment decision-making (hurdle
rates)

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 Mean-Variance Portfolio
Selection vs. the CAPM
n Mean-Variance analysis gives us a way to select
a portfolio, given expected returns, variances
and covariances
n Doesnt tell us anything about what price should be

n If everyone holds a mean-variance optimal

portfolio, what does it mean for supply/
demand of the asset?

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 Mean-Variance Portfolio
Selection vs. the CAPM
n The CAPM is a general equilibrium model
which assumes:
1) everyone agrees on statistical properties of returns.
2) people have different parameters of risk aversion
3) portfolio optimization as correct
n The CAPM predicts:
q Gives the relation between the expected rate of
return and the return covariances for all assets
q Talks about what the valuation of systemic vs
idiosyncratic risk.

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 Equilibrium
n An equilibrium is a set of strategies (=planned
strategic behavior) by participants such that:
q These strategies only depend on information
available when decision was made
q Given everything the agent knows and knowledge of
planned strategies of other participants, no agent
wishes to change his strategy.

n A situation where no agent (investor) wants

to do anything differently
q We need this concept to come up with a pricing
model. Think game theoretical model.

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 Equilibrium

n If everyone holds the efficient portfolio, then

what do prices need to be so that markets
clear?

n How should securities be priced so that

investors want to hold exactly 100% of the
available assets?
n Prices are discounted expected dividends, so
n Low required returns high prices
n High required returns low prices

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 Example
n Suppose that based on expected returns
(=prices) our model comes up with, no agent
holds long the stock of IBM.
n Then somethings wrong. Our model predicts a price of
IBM which is too high and does not make sense.
n If no one holds IBM, then its price will fall
q Thats just supply and demand
n How far should its price fall?
q To the point where investors want, in aggregate,
to hold exactly the number of IBM shares
outstanding!

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 Inductive Step
n Investors in aggregate hold all securities
outstanding in the market.

n Assumptions:
q All investors hold the tangency portfolio, and
q Prices adjust to clear markets

n Results:
q Tangency portfolio has to be the Market
Portfolio.

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 What is the Market?
We almost always think of this as the stock market
n But it really should include all securities
q Bonds
q Real Estate
n And our allocation theory completely ignored
things like human capital
q E.g., negative covariance with job prospects is also
attractive
q Should have traded off marginal rewards with
marginal variance of total wealth
n Not just portfolio wealth

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 The Capital Market Line
n When the tangency portfolio is the market
portfolio, we call the CAL the Capital Market
Line
q Two-fund separation then says all investors should
hold a combination of just the market and T-bills
n Where market should really be the total wealth portfolio!
q Which includes even human capital

n This is the whole basis for passive investing

q Or index investing
n Has had a profound impact on money management
industry

FIN 411: CAPM Prof. Dmitry Orlov 11

 Capital Market Line
0.2

Here the MVE

portfolio is the
market
Expected Return

Stock D
MVE
0.1 Stock C

0.05 Stock A

Stock B
0.01
0
0 0.05 0.1 0.15 0.2 0.3
Volatility

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 How are stocks priced?
n If
tangency portfolio = market portfolio,
then what is the expected return on stock i?
q MVE portfolio condition is that marginal reward =
marginal risk
cov [
cov [
rrii,,rrMV
MVEE]] =
= (E
(E[
[
rri i]] rrff))cc for
for i i ==1,
1,......,,NN

q This is equivalent to:

EE[
[
rrii]] rrff EE[
[
rrjj]] rrff
=
= for i,i,jj ==1,
for 1,......,,NN
cov [
cov [
rrii,,rrMV
MVEE]] cov[
cov [
rrjj,,rrMV
MVEE]]

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 cov [
ri , rMV E ] = (E [
ri ] rf ) c for i = 1, . . . , N
Expected Returns
n Condition
ri ] rfholds for E
E [ anyrj ]portfolio,
[ rf
nSo in particular,=must hold for the tangency
for portfolio
i , j = 1, ...,N
itself
cov [
ri , rMV E ] cov [rj , rMV E ]

E [
ri ] rf E [
rMV E ] rf
= for i = 1, . . . , N
cov [
ri , rMV E ] var [
rMV E ]

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cov [
ri , rMV E ] cov [
rj , rMV E ]

ri ] rf Expected
E [ rMV E ] Returns
E [ rf
= for i = 1, . . . , N
cov [
ri , rMV E ] var [
rMV E ]
n Previous equation can be rewritten as

cov [
ri , rMV E ]
E [
ri ] = rf + (E [
rMV E ] rf )
var [rMV E ]
q This equation links an assets
1. Expected return
2. To its risk
n What is the relevant measure of risk?
q Its the covariance between an assets return and the return on
the tangency portfolio

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 cov [
= Security r= MV E ]= 9.4%
i , r0.094
0.055 Market Line
+ 0.039
i =
var [
rMV E ]
n For stock i define:
cov [
ri , rMV E ]
i =e e
E [ var [
ri ] = EE [
ri MV ]rmkt ]
n Beta is a measure of risk for a given stock.
n Mean variance analysis says that:
E [
ri ] = rf + i E [rMV E rf ]

n View it as a function of stocks i beta.

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 Security Market Line
n Security market line: mapping betweek beta
and expected return.
All securities
(should) lie on the
SML

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 cov [
ri , rMV E ] var [
rMV E ]
ri ] What
= rf + is the risk?
cov [ ri , rMV E ]
E [ (E [
rMV E ] rf )
var [ rMV E ]
n Generally call it cov [
ri , rMV E ]
beta
E [
ri ] = rf + (E [
rMV E ] rf )
q
var [
If we regress a stocks MV E ] on the markets returns:
rreturns

ri,t rf ,t = i + i (
rMV E,t rf ,t ) + "i,t

q
ri,tmeasures
Beta rf ,t = i +
the i (
slope rMV
of a stocks
E,t ) + "i,t on the
rf ,t returns
market
n Its Ordinary Least Squares (OLS) estimate is exactly

i = cov [
ri , rMV E ]
var [rMV E ]
n When market goes up 1% how much, on average, does the
stock go up?

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 Example
n Estimate IBMs beta, regressing IBMs excess returns on the
markets
n Can visualize this by plotting IBMs excess returns against the
markets:
rIBM rf = 0.000004 + 0.7495 (
rS&P rf )

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 Testing CAPM
ri,t rf ,t = i + i (
rMV E,t rf ,t ) + "i,t
n 2nd term: stocks returns explained by market
q systematic risk (or market risk)
n cov [
priced risk!
i = ri ,
rMV E ]
n 3 term: the variationvar
rd not[ explained
rMV E] by the
market
q idiosyncratic risk (or unsystematic risk)
n unpriced or diversifiable risk!
n 1st term: abnormal returns (relative to the
market)
q What should this be?

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 Estimating Betas
n Betas may change over time, so dont use too
old data
q Five years of monthly data is reasonable
n And relatively common, in practice
n Sometimes use higher frequency data (daily), and shorter
windows
n Estimated betas are noisy
q Whats our prior on beta?
n Industry often puts:
q A 2/3 weight on 1 (the average stocks beta)
q A 1/3 weight on the sample estimate

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 i
var [
rMV E ]
cov [
r ,
r ]
CAPM
i = pricing equation
i MV E
var [rMV E ]
n Take expectations of the return equation
And using theEfact ethat the intercepteshould be zero
q
ri ] = i E [
[ rmkt ]
e e
E [ri ] = i E [ rmkt ]
q Can also write
e
E [
ri ] = rf + i E [rmkt rf ]
q Relates a stocks expected return directly to its risk
n Risk measured by covariance with the market
n NOT volatility

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FIN 411: CAPM Prof. Dmitry Orlov 23
 Application
n Example: ri ] = rf + ia stocks
E [
Suppose E [rMV E beta
rf ] is 0.6, risk-
free rate is 5.5%, and expected market return is
12%. Whats the stocks expected return?
q Solution. Using the CAPM formula,
E [
ri ] = rf + i E [rmkt rf ]

= 0.055 + 0.6 (0.12 0.055)

= 0.055 + 0.039 = 0.094 = 9.4%

q Expected return required to compensate for its risk
q For valuation, 9.4% is the discount rate in the PV
formula cov [
ri , rMV E ]
i =
n discount rate = required
var [rrate of return = expected return
MV E ]

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 Some Issues
n The CAPM is wrong!
q At least empirically
n Using the market

n Even so, there are several reasons we spend

time with it
q The intuition behind the CAPM is the basis for the
more advanced asset pricing models that we will
look at later
q And the standard against which they will be
measured

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 Testing the CAPM
n Average rates of return differ widely from asset
to asset
q Example: stocks versus bonds
n In theory, these differences should be due to
differences in risk
q Riskier assets should have higher average returns to
compensate us
q In CAPM risk = beta
q So betas should explain all differences in average
returns

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 Testing the CAPM

n To test the CAPM:

q Take a large number of stocks over some time
period (say, 1975-1980) and estimate their betas
q Then, compute each stocks average returns over the
subsequent time period (say, 1980-1985)
q Do average returns line up with betas?

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 Testing the CAPM
n Black, Jensen, and Scholes (1972) do this
q Higher beta stocks do earn higher returns on
average,
q But not higher enough!
n Low beta stocks have higher returns than the formula
predicts
q I.e., the have positive alphas
n High beta stocks have lower returns than the formula
predicts
q I.e., the have negative alphas

q Also, some stock characteristics explain

average returns better than beta

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 r i Alpha
i + i (r M
rf = rf )
n Remember the regression:

ri i + i (r M
rf = rf )
n Can rewrite this equation in terms of :
i = r i
rf i (r M rf )

= ri (rf + i (r M rf ))
q isi difference
= r i between i we
rf what (r
got, )
rf we
Mand what
expected

FIN 411: CAPM

=r (r + (r
Prof. Dmitry Orlov
r )) 29
 Alpha
n If > 0, could be one of two possibilities:
q The security got lucky
n And the CAPM might still be true
q The security actually earned its expected return
n But then the CAPM is wrong!
q Could be that there are mispricings
Which some stock pickers might be able to exploit
The entire hedge fund industry is about alpha
q Could also be that the stock is riskier than the CAPM predicts
Need a better model

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 Does the CAPM work?
n There is a big problem in testing the CAPM:
q Roll (1977): CAPM is untestable, because the true
market portfolio (w/real estate, human capital, etc.)
isnt observable

q Using S&P 500 as proxy for market index, only

testing if S&P 500 is MVE, which does not test the
CAPM
n So cant know if the CAPM is wrong, or
n If our market proxy just isnt good enough
n No matter what we think, CAPM is widely used
q Imperfect, but useful (Mullins 1982)

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 Beyond the CAPM
n Later work by Fama and French (1992) find even
less support for the CAPM
q Find no relation between and average returns,
n After controlling for firm size (market capitalization) and the
book equity-to-market equity ratio
q Leads them to pronounce beta is dead!
q We will talk about their conclusionsand remediesin
later lectures

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