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CHAPTER TEN
THE CAPITAL ASSET PRICING
MODEL
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THE CAPM ASSUMPTIONS
NORMATIVE ASSUMPTIONS
expected returns and standard deviation cover a
one-period investor horizon
nonsatiation
risk averse investors
assets are infinitely divisible
risk free asset exists
no taxes nor transaction costs
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THE CAPM ASSUMPTIONS
ADDITIONAL ASSUMPTIONS
one period investor horizon for all
risk free rate is the same for all
information is free and instantaneously
available
homogeneous expectations
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THE CAPITAL MARKET LINE
THE CAPITAL MARKET LINE (CML)
the new efficient frontier that results from risk
free lending and borrowing
both risk and return increase in a linear fashion
along the CML
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THE CAPITAL MARKET LINE
THE CAPITAL MARKET LINE
M
r
P

o
P

CML
rfr
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THE CAPITAL MARKET LINE
THE SEPARATION THEOREM
James Tobin identifies:
the division between the investment decision and the
financing decision
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THE CAPITAL MARKET LINE
THE SEPARATION THEOREM
to be somewhere on the CML, the investor
initially
decides to invest and
based on risk preferences makes a separate
financing decision either
to borrow or
to lend
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THE MARKET PORTFOLIO
DEFINITION: the portfolio of all risky
assets which contains
complete diversification
a central role in the CAPM theory which is the
tangency portfolio (M) with the CML
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THE SECURITY MARKET LINE
(SML)
FOR AN INDIVIDUAL RISKY ASSET
the relevant risk measure is its covariance with
the market portfolio (o
i, M
)
DEFINITION: the security market line
expresses the linear relationship between
the expected returns on a risky asset and
its covariance with the market returns
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THE SECURITY MARKET LINE
(SML)
THE SECURITY MARKET LINE


or

where
m i
m
rf m
rf
r r
r r
,
2
o
o
(
(

+ =
M i rf rf
i
r r r r
, 2
) ( | + =
2
,
,
M
M i
M i
o
o
| =
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THE SECURITY MARKET LINE
(SML)
THE SECURITY MARKET LINE
THE BETA COEFFICIENT
an alternative way to represent the covariance of a
security

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THE SECURITY MARKET LINE
(SML)
THE SECURITY MARKET LINE
THE BETA COEFFICIENT
of a portfolio
is the weighted average of the betas of its component
securities


=
=
N
i
M i i M P
X
1
, ,
| |
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THE SECURITY MARKET LINE
(SML)
THE SECURITY MARKET LINE
SML
|
E(r)
r
rf

r
M

| =1.0
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THE MARKET MODEL
FROM CHAPTER 7
assumed return on a risky asset was related to
the return on a market index

iI I i iI i
r r c | o + + =
1
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THE MARKET MODEL
DIFFERENCES WITH THE CAPM
the market model is a single-factor model
the market model is not an equilibrium model
like the CAPM
the market model uses a market index,
the CAPM uses the market portfolio
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THE MARKET MODEL
MARKET INDICES
the most widely used and known are
S&P 500
NYSE COMPOSITE
AMEX COMPOSITE
RUSSELL 3000
WILSHIRE 5000
DJIA
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THE MARKET MODEL
MARKET AND NON-MARKET RISK
Recall that a securitys total risk may be
expressed as

2 2 2 2
i i iI i c
o o | o + =
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THE MARKET MODEL
MARKET AND NON-MARKET RISK
according to the CAPM
the relationship is identical except the market
portfolio is involved instead of the market index
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THE MARKET MODEL
MARKET AND NON-MARKET RISK
Why partition risk?
market risk
related to the risk of the market portfolio and to the beta of
the risky asset
risky assets with large betas require larger amounts of
market risk
larger betas mean larger returns
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THE MARKET MODEL
MARKET AND NON-MARKET RISK
Why partition risk?
non-market risk
not related to beta
risky assets with larger amounts of o
cI
will not have
larger E(r)
According to CAPM
investors are rewarded for bearing market risk not non-
market risk