Investments, 8

th
edition
Bodie, Kane and Marcus
Slides by Susan Hine
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
CHAPTER 9
The Capital Asset
Pricing Model
9-2
• It is the equilibrium model that underlies all
modern financial theory
• Derived using principles of diversification with
simplified assumptions
• Markowitz, Sharpe, Lintner and Mossin are
researchers credited with its development
Capital Asset Pricing Model (CAPM)
9-3
• Individual investors are price takers
• Single-period investment horizon
• Investments are limited to traded financial
assets
• No taxes and transaction costs
Assumptions
9-4
• Information is costless and available to all
investors
• Investors are rational mean-variance
optimizers
• There are homogeneous expectations
Assumptions Continued
9-5
• All investors will hold the same portfolio for
risky assets – market portfolio
• Market portfolio contains all securities and
the proportion of each security is its market
value as a percentage of total market value
Resulting Equilibrium Conditions
9-6
• Risk premium on the market depends on the
average risk aversion of all market
participants
• Risk premium on an individual security is a
function of its covariance with the market
Resulting Equilibrium Conditions
Continued
9-7
Figure 9.1 The Efficient Frontier and the
Capital Market Line
9-8
Market Risk Premium
•The risk premium on the market portfolio will
be proportional to its risk and the degree of risk
aversion of the investor:


2
2
( )
where is the variance of the market portolio and
is the average degree of risk aversion across investors
M f M
M
E r r A
A
o
o
÷ =
9-9
• The risk premium on individual securities is a
function of the individual security’s
contribution to the risk of the market portfolio
• An individual security’s risk premium is a
function of the covariance of returns with the
assets that make up the market portfolio
Return and Risk For Individual Securities
9-10
Using GE Text Example
• Covariance of GE return with the market
portfolio:


• Therefore, the reward-to-risk ratio for
investments in GE would be:

1 1
( , ) , ( , )
n n
GE M GE k k k k GE
k k
Cov r r Cov r w r w Cov r r
= =
| |
= =
|
\ .
¿ ¿
( )
( )
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
( ÷
÷
¸ ¸
= =
9-11
Using GE Text Example Continued
• Reward-to-risk ratio for investment in
market portfolio:


• Reward-to-risk ratios of GE and the market
portfolio:

• And the risk premium for GE:
2
( )
Market risk premium
Market variance
M f
M
E r r
o
÷
=
2
( ) ( ( )
( , )
GE f M f
GE M M
E r r E r r
Cov r r o
÷ ÷
=
2
( , )
( ) ( )
GE M
GE f M f
M
Cov r r
E r r E r r
o
(
÷ = ÷
¸ ¸
9-12
Expected Return-Beta Relationship
• CAPM holds for the overall portfolio because:



• This also holds for the market portfolio:
P
( ) ( ) and
P k k
k
k k
k
E r w E r
w | |
=
=
¿
¿
( ) ( )
M f M M f
E r r E r r |
(
= + ÷
¸ ¸
9-13
Figure 9.2 The Security Market Line
9-14
Figure 9.3 The SML and a Positive-
Alpha Stock
9-15
The Index Model and Realized Returns
• To move from expected to realized returns—
use the index model in excess return form:


• The index model beta coefficient turns out to
be the same beta as that of the CAPM
expected return-beta relationship
i i i M i
R R e o | = + +
9-16
Figure 9.4 Estimates of Individual Mutual
Fund Alphas, 1972-1991
9-17
The CAPM and Reality
• Is the condition of zero alphas for all stocks
as implied by the CAPM met
– Not perfect but one of the best available
• Is the CAPM testable
– Proxies must be used for the market
portfolio
• CAPM is still considered the best available
description of security pricing and is widely
accepted
9-18
Econometrics and the Expected Return-
Beta Relationship
• It is important to consider the econometric
technique used for the model estimated
• Statistical bias is easily introduced
– Miller and Scholes paper demonstrated
how econometric problems could lead one
to reject the CAPM even if it were perfectly
valid
9-19
Extensions of the CAPM
• Zero-Beta Model
– Helps to explain positive alphas on low
beta stocks and negative alphas on high
beta stocks
• Consideration of labor income and non-
traded assets
• Merton’s Multiperiod Model and hedge
portfolios
– Incorporation of the effects of changes in
the real rate of interest and inflation
9-20
Extensions of the CAPM Continued
• A consumption-based CAPM
– Models by Rubinstein, Lucas, and Breeden
• Investor must allocate current wealth between
today’s consumption and investment for the future
9-21
Liquidity and the CAPM
• Liquidity
• Illiquidity Premium
• Research supports a premium for illiquidity.
– Amihud and Mendelson
– Acharya and Pedersen
9-22
Figure 9.5 The Relationship Between
Illiquidity and Average Returns
9-23
Three Elements of Liquidity
• Sensitivity of security’s illiquidity to market
illiquidity:

• Sensitivity of stock’s return to market
illiquidity:

• Sensitivity of the security illiquidity to the
market rate of return:

1
( , )
( )
i M
L
M M
Cov C C
Var R C
| =
÷
3
( , )
( )
i M
L
M M
Cov C R
Var R C
| =
÷
2
( , )
( )
i M
L
M M
Cov R C
Var R C
| =
÷

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