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2.the Capital Asset Pricing Model and Its Application to Performance Measurement

2.the Capital Asset Pricing Model and Its Application to Performance Measurement

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4The Capital Asset Pricing Model andits Application to PerformanceMeasurement
1
In Chapter 3 we described Markowitz’s portfolio analysis model and presented the empiricalmarketmodel.ThelatterwasdevelopedbySharpeinordertosimplifythecalculationsinvolvedin the Markowitz model and thereby render it more operational. The next step in financialmodelling was to study the influence of the behaviour of investors, taken as a whole, on assetprices. What resulted was a theory of asset valuation in an equilibrium situation, drawingtogether risk and return.The model that was developed is called the Capital Asset Pricing Model (CAPM). Severalauthors have contributed to this model. Sharpe (1963, 1964) is considered to be the forerunner and received the Nobel Prize in 1990. Treynor (1961) independently developed a model thatwas quite similar to Sharpe’s. Finally, Mossin (1966), Lintner (1965, 1969) and Black (1972)made contributions a few years later.Thismodelwasthefirsttointroducethenotionofriskintothevaluationofassets.Itevaluatesthe asset return in relation to the market return and the sensitivity of the security to the market.It is the source of the first risk-adjusted performance measures. Unlike the empirical marketline model, the CAPM is based on a set of axioms and concepts that resulted from financialtheory.Thefirstpartofthischapterdescribesthesuccessivestagesthatproducedthemodel,together with the different versions of the model that were developed subsequently. The followingsections discuss the use of the model in measuring portfolio performance.
4.1 THE CAPM
4.1.1 Context in which the model was developed
4.1.1.1 Investor behaviour when there is a risk-free assetMarkowitz studied the case of an investor who acted in isolation and only possessed riskyassets. This investor constructs the risky assets’ efficient frontier from forecasts on expectedreturns, variance and covariance, and then selects the optimal portfolio, which corresponds tohis/her level of risk aversion on the frontier.We always assume that the Markowitz assumptions are respected. Investors are thereforerisk averse and seek to maximise the expected utility of their wealth at the end of the period.They choose their portfolios by considering the first two moments of the return distributiononly, i.e. the expected return and the variance. They only consider one investment period andthat period is the same for everyone.
1
Numerous publications describe the CAPM and its application to performance measurement. Notable inclusions are Broquetand van den Berg (1992), Fabozzi (1995), Elton and Gruber (1995) and Farrell (1997).
 
98 Portfolio Theory and Performance Analysis
4.1.1.2 Equilibrium theoryUp until now we have only considered the case of an isolated investor. By now assuming thatall investors have the same expectations concerning assets, they all then have the same return,variance and covariance values and construct the same efficient frontier of risky assets. In thepresenceofarisk-freeasset,thereasoningemployedforoneinvestorisappliedtoallinvestors.The latter therefore all choose to divide their investment between the risk-free asset and thesame risky asset portfolio
.Now, for the market to be at equilibrium, all the available assets must be held in portfolios.The risky asset portfolio
, in which all investors choose to have a share, must thereforecontain all the assets traded on the market in proportion to their stock market capitalisation.This portfolio is therefore the market portfolio. This result comes from Fama (1970).In the presence of a risky asset, the efficient frontier that is common to all investors is thestraight line of the following equation:E(
 R
P
)
=
R
F
+
E(
 R
 M 
)
 R
F
σ 
 M 
σ 
P
This line links the risk and return of efficient portfolios linearly. It is known as the capitalmarket line.These results, associated with the notion of equilibrium, will now allow us to establish arelationship for individual securities.
4.1.2 Presentation of the CAPM
We now come to the CAPM itself (cf. Briys and Viala, 1995, and Sharpe, 1964). This modelwill help us to define an appropriate measure of risk for individual assets, and also to evaluatetheir prices while taking the risk into account. This notion of the “price” of risk is one of theessential contributions of the model.The development of the model required a certain number of assumptions. These involvethe Markowitz model assumptions on the one hand and assumptions that are necessary for market equilibrium on the other. Some of these assumptions may seem unrealistic, but later versions of the model, which we shall present below, allowed them to be scaled down. All of the assumptions are included below.4.1.2.1 CAPM assumptions
3
The CAPM assumptions are sometimes described in detail in the literature, and sometimesnot, depending on how the model is presented. Jensen (1972a) formulated the assumptionswith precision. The main assumptions are as follows:1. Investors are risk averse and seek to maximise the expected utility of their wealth at the endof the period.2. When choosing their portfolios, investors only consider the first two moments of returndistribution: the expected return and the variance.3. Investors only consider one investment period and that period is the same for all investors.
3
These assumptions are described well in Chapter 5 of Fabozzi (1995), in Cobbaut (1997), in Elton and Gruber (1995) and inFarrell (1997), who clearly distinguishes between the Markowitz assumptions and the additional assumptions.
 
102 Portfolio Theory and Performance Analysis
practice, is approximated by a well-diversified portfolio. Equilibrium theory, which underliesthe model, favoured the development of passive management and index funds, since it showsthat the market portfolio is the optimal portfolio. The model also paved the way for thedevelopment of more elaborate models based on the use of several factors.4.1.2.4 Market efficiency and market equilibriumAn equilibrium model can only exist in the context of market efficiency. Studying marketefficiency enables the way in which prices of financial assets evolve towards their equilibriumvalue to be analysed. Let us first of all define market efficiency and its different forms.The first definition of market efficiency was given by Fama (1970): markets are efficient if the prices of assets immediately reflect all available information. Jensen (1978) gave a moreprecise definition: in an efficient market, a forecast leads to zero profits, i.e. the expensesincurred in searching for information and putting the information to use offset the additionalprofit procured (cf. Hamon, 1997).Thereareseveraldegreesofmarketefficiency.Efficiencyissaidtobeweakiftheinformationonly includes past prices; efficiency is semi-strong if the information also includes publicinformation;efficiencyisstrongifallinformation,publicandprivate,isincludedinthepresentprices of assets. Markets tend to respect the weak or semi-strong form of efficiency, but theCAPM’s assumption of perfect markets refers in fact to the strong form.The demonstration of the CAPM is based on the efficiency of the market portfolio at equi-librium. This efficiency is a consequence of the assumption that all investors make the sameforecasts concerning the assets. They all construct the same efficient frontier of risky assetsand choose to invest only in the efficient portfolios on this frontier. Since the market is theaggregation of the individual investors’ portfolios, i.e. a set of efficient portfolios, the marketportfolio is efficient.In the absence of this assumption of homogeneous investor forecasts, we are no longer assured of the efficiency of the market portfolio, and consequently of the validity of theequilibrium model. The theory of market efficiency is therefore closely linked to that of theCAPM. It is not possible to test the validity of one without the other. This problem constitutesan important point in Roll’s criticism of the model. We will come back to this in more detailat the end of the chapter.The empirical tests of the CAPM involve verifying, from the empirical formulation of themarket model, that the
ex-post 
value of alpha is nil.
4.1.3 Modified versions of the CAPM
5
Since the original assumptions of the CAPM are very restrictive, several authors have studiedthe consequences for the model of not respecting the assumptions. The studies address oneassumption at a time. Chapter 14 of Elton and Gruber (1995) is very exhaustive on the subject.Among the versions of the model that were developed in this way, the most interesting from apracticalapplicationviewpointareBlack’szero-betamodelandBrennan’smodel,whichtakes
5
We can refer to Chapter 7 of Copeland and Weston (1988) for a detailed presentation with a demonstration of the Black andMerton models and to Chapter 8 for the Brennan model. Poncet
et al
. (1996) give a description without a demonstration of the Blackand Merton models, Chapter 3 of Farrell (1997) presents the Black and Brennan models, and Chapter 14 of Elton and Gruber (1995)is devoted to the non-standard forms of the CAPM.

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