CAPM

Capital Asset Pricing Model

Modern Portfolio Theory and
diversification
Rational investors use diversification to
optimize their portfolios
Diversification reduces portfolio risk
(assets that are not perfectly correlated)
Efficient Portfolio
Beta vs. standard deviation
Standard deviation includes systematic
and unsystematic risk; not used because
unsystematic risk diversified away

Beta: A standardized measure of the risk

of an individual asset, one that captures
only the systematic component of its
volatility; measures how sensitive an
individual security is to market
movements; measure of market risk
Unsystematic vs. systematic risk
Unsystematic risk: risk that can be eliminated
through diversification
a.k.a. Unique risk, residual risk, specific risk, or diversifiable risk

Systematic risk: risk that cannot be

eliminated through diversification
a.k.a, market risk or undiversifiable risk
Capital Asset Pricing Model
(CAPM)

The expected return on a specific asset equals

the risk-free rate plus a premium that depends
on the assets beta and the expected risk
premium on the market portfolio.

Expected return of specific asset: E(Ri)

Risk-free rate: Rf
Expected risk premium: E(Rm) - Rf
Practice Problem #1
If the risk-free rate equals 4% and a stock
with a beta of 0.8 has an expected return
of 10.4%, what is the expected return on
the market portfolio?
Practice Problem #2
A particular asset has a beta of 1.2 and an
expected return of 10%. Given that the
expected return on the market portfolio is
13% and the risk-free rate is 5%, the stock
is:
A. appropriately priced
B. underpriced
C. overpriced
Practice Problem #3
Last year
Firm A: return: 10%, beta: 0.8
Firm B: return: 11%, beta: 1.0
Firm C: return: 12%, beta: 1.2
Given that the risk-free rate was 3% and
market return was 11%, which firm had the
best performance?
Assumptions behind the CAPM
U.S. treasuries are risk-free
Uncertainty about inflation
Assumed that investors can borrow money
at same interest rate at which they lend,
but generally borrowing rates are higher
than lending rates
WHY we still use CAPM: benchmark
portfolios used Treausry bills and
market portfolio
Asset pricing
Future cash flows of the asset can be
discounted using the expected return
calculated from CAPM to establish the
price of the asset
If observed price > CAPM valuation
overvalued (paying too much for that
amount of risk)
If observed price < CAPM valuation
undervalued
Security Market Line
Line representing the relationship between
expected return and market risk; shows
expected return of an overall market as a
function of systematic risk
Graphical representation of CAPM
Compare a single asset to the SML (and
see if it falls below, above, or on the line)
Security Market Line
Example