55 Notes On Capm

Chapter 11
Capital Asset Pricing Model

(CAPM)
Road Map
Part A Introduction to nance.
Part B Valuation of assets, given discount rates.
Part C Determination of discount rates.
Historic asset returns.
Time value of money.
Risk.
Portfolio theory.
Capital Asset Pricing Model (CAPM).
Arbitrage Pricing Theory (APT).
Part D Introduction to corporate nance.
Main Issues
Derivations of CAPM
Implications of CAPM
Empirical Evidence
11-2 Capital Asset Pricing Model (CAPM) Chapter 11
Contents
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . 11-3
2 The Market Portfolio . . . . . . . . . . . . . . . . . . . . . . 11-4
3 Derivation of CAPM . . . . . . . . . . . . . . . . . . . . . . 11-5
3.1 A Numerical Illustration of CAPM . . . . . . . . . . . . . . . . . 11-6
3.2 A Formal Derivation of CAPM . . . . . . . . . . . . . . . . . . . 11-8
3.3 Implications of CAPM . . . . . . . . . . . . . . . . . . . . . . . . 11-9
4 Understanding Risk in CAPM . . . . . . . . . . . . . . . . . 11-12
5 Applications of CAPM . . . . . . . . . . . . . . . . . . . . . 11-18
6 Empirical Evaluation of CAPM . . . . . . . . . . . . . . . . . 11-20
7 Summary of CAPM . . . . . . . . . . . . . . . . . . . . . . . 11-23
8 Appendix A: Capital Market Line . . . . . . . . . . . . . . . 11-24
9 Appendix B: Extensions of CAPM . . . . . . . . . . . . . . . 11-25
9.1 Multifactor CAPM . . . . . . . . . . . . . . . . . . . . . . . . . 11-25
9.2 Consumption CAPM (CCAPM) . . . . . . . . . . . . . . . . . . . 11-28
10 Homework . . . . . . . . . . . . . . . . . . . . . . . . . . . 11-31
15.407 Lecture Notes Fall 2003 c Jiang Wang
Chapter 11 Capital Asset Pricing Model (CAPM) 11-3
1 Introduction
Portfolio theory analyzes investors asset demand given asset
returns.
This chapter studies how investors asset demand determines the
relation between assets risk and return in a market equilibrium
(when demand equals supply).
A model to price risky assets.
Main question of this chapter
E[ r
i
] = ?
Main points of portfolio theory
1. Diversify to eliminate non-systematic risk.
2. Hold only the risk-free asset and the tangent portfolio.
3. An assets systematic risk is measured by contribution to the
risk of the tangent portfolio its beta
iT
.
4. An assets risk premium is proportional to its systematic risk:
r
i
r
F
=
iT
( r
T
r
F
) .
Identifying the tangent portfolio gives a pricing model.
c Jiang Wang Fall 2003 15.407 Lecture Notes
2 The Market Portfolio
Denition: The market portfolio is the portfolio of all risky assets
traded in the market.
Denition: The market capitalization of an asset is its total
market value.
Suppose there are a total of i = 1, . . . , n risky assets. Asset is
market capitalization is
MCAP
i
= (price per share)
i
(# of shares outstanding)
i
.
The total market capitalization of all risky assets is
MCAP
M
=
n
i=1
MCAP
i
.
The market portfolio is the portfolio with weights in each risky
asset i being
w
i
=
MCAP
i
n
j=1
MCAP
j
=
MCAP
i
MCAP
M
.
We denote the market portfolio by ww w
M
.
3 Derivation of CAPM
Assumptions for this chapter:
1. Investors agree on the distribution of asset returns.
2. Investors have the same xed (static) investment horizon.
3. Investors hold ecient frontier portfolios.
4. There is a risk-free asset:
paying interest rate r
F
in zero net supply.
5. Demand of assets equals supply in equilibrium.
Implications:
1. Every investor puts their money into two pots:
the riskless asset
a single portfolio of risky assets the tangent portfolio.
2. All investors hold the risky assets in same proportions
they hold the same risky portfolio, the tangent portfolio.
3. The tangent portfolio is the market portfolio.
3.1 A Numerical Illustration of CAPM
CAPM requires that in equilibrium total asset holdings of all
investors must equal the total supply of assets.
We show this through the example below.
There are only three risky assets, A, B and C. Suppose that the
tangent portfolio is
ww w
T
= (w
A
, w
B
, w
C
) = (0.25, 0.50, 0.25).
There are only three investors in the economy, 1, 2 and 3, with
total wealth of 500, 1000, 1500 billion dollars, respectively. Their
asset holdings (in billion dollars) are:
Investor Riskless A B C
1 100 100 200 100
2 200 200 400 200
3 -300 450 900 450
Total 0 750 1500 750
Claim:
The market portfolio is the tangent portfolio:
ww w
M
= ww w
T
.
In equilibrium, the total dollar holding of each asset must equal
its market value:
Market capitalization of A = $750 billion
Market capitalization of B = $1500 billion
Market capitalization of C = $750 billion.
The total market capitalization is
750 +1500 +750 = $3, 000 billion.
The market portfolio is the tangent portfolio:
ww w
M
=
_
750
3000
,
1500
3000
,
750
3000
_
= (0.25, 0.50, 0.25) = ww w
T
.
0. 00
0. 50
1. 00
1. 50
2. 00
2. 50
3. 00
3. 50
4. 00
4. 50
5. 00
0. 0 1. 0 2. 0 3. 0 4. 0 5. 0 6. 0 7. 0 8. 0 9. 0 10. 0
Standard Deviation (%, per month)
R
e
t
u
r
n

(
%
,

p
e
r

m
o
n
t
h
)
T = M
Efficiency frontier
3.2 A Formal Derivation of CAPM
(1) There are k = 1, 2, . . . , K investors.
(2) Investor k has wealth W
k
and invests in two funds:
W
k
F
in riskless asset
W
k
W
k
F
in the tangent portfolio ww w
T
.
Market equilibrium demand equals supply:
1. Money market equilibrium:
K
k=1
W
k
F
= 0 (risk-free asset is in zero net supply)
2. Stock market equilibrium:
K
k=1
_
W
k
W
k
F
_
ww w
T
= MCAP
M
ww w
M
.
Since the net amount invested in the risk-free asset is zero, all
wealth is invested in stocks:
K
k=1
W
k
= MCAP
M
.
Thus, the total wealth of investors equals the total value of stocks:
ww w
T
= ww w
M
.
The tangent portfolio is the market portfolio!
3.3 Implications of CAPM
1. The market portfolio is the tangent portfolio.
2. Combining the risk-free asset and the market portfolio gives
the portfolio frontier.
3. The risk of an individual asset is characterized by its covari-
ability with the market portfolio.
4. The part of the risk that is correlated with the market portfolio,
the systematic risk, cannot be diversied away.
Bearing systematic risk needs to be rewarded.
5. The part of an assets risk that is not correlated with the
market portfolio, the non-systematic risk, can be diversied
away by holding a frontier portfolio.
Bearing nonsystematic risk need not be rewarded.
6. For any asset i:
E[ r
i
] r
F
=
iM
(E[ r
M
] r
F
) (11.1)
where
iM
=
iM
/
2
M
.
Given the premium of market portfolio, the riskless rate and
assets market betas, equation (11.1) determines the premium of
all assets.
We thus have an asset pricing model the CAPM.
The relation between an assets risk premium and its market beta
is called the Security Market Line (SML).
Security Market Line (SML)
-
6
E[ r]
M
=1
r
F
r
M
r
i
SML
v
M
` ` ` ` ` ` ` ` ` ` ` ` ` ` ` `
`
`
`
`
`
`
`
`
`
`
`
`
`
s
_
_
r
M
r
F
Example. Suppose that CAPM holds. The expected market
return is 14% and T-bill rate is 5%.
1. What should be the expected return on a stock with = 0?
Answer: Same as the risk-free rate, 5%. Note:
The stock may have signicant uncertainty in its return.
This uncertainty is uncorrelated with the market return.
2. What should be the expected return on a stock with = 1?
Answer: The same as the market return, 14%.
3. What should be the expected return on a portfolio made up
of 50% T-bills and 50% market portfolio?
Answer: the expected return should be
r = (0.5)(0.05) +(0.5)(0.14) = 9.5%.
4. What should be expected return on stock with = 0.6?
Answer: The expected return should be
r = 0.05 +(0.6)(0.14 0.05) = 0.4%.
How can this be?
4 Understanding Risk in CAPM
In CAPM, we can decompose an assets return into three pieces:
r
i
r
F
=
i
+
iM
( r
M
r
F
) +
i
where
E[
i
] = 0
Cov[ r
M
,
i
] = 0.
Three characteristics of an asset:
Beta.
Sigma = StD (
i
).
Alpha.
Beta
r
i
r
F
=
i
+
iM
( r
M
r
F
) +
i
Beta measures an assets systematic risk.
Assets with higher betas are more sensitive to the market.
Two assets with same total volatility but dierent betas
10 20 30 40
0.5
0
0.5
1
1.5
2
asset beta = 0.2
time
r
e
t
u
r
n
10 20 30 40
0.5
0
0.5
1
1.5
2
asset beta = 1.2
time
r
e
t
u
r
n
0.4 0.6 0.8 1 1.2
0.5
0
0.5
1
1.5
2
market return
a
s
s
e
t

r
e
t
u
r
n
0.4 0.6 0.8 1 1.2
0.5
0
0.5
1
1.5
2
market return
a
s
s
e
t

r
e
t
u
r
n
(Market premium = 8%, market volatility = 25%, asset volatility = 40%.)
Solid lines asset rturns. Dotted lines market returns.
Sigma
r
i
r
F
=
i
+
iM
( r
M
r
F
) +
i
An assets sigma measures its non-systematic risk.
Non-systematic risk is uncorrelated with systematic risk.
Two assets with same total volatility but dierent betas
10 20 30 40
0.5
0
0.5
1
1.5
asset beta = 0.2
time
r
e
t
u
r
n
10 20 30 40
0.5
0
0.5
1
1.5
asset beta = 1.2
time
r
e
t
u
r
n
10 20 30 40
0.5
0
0.5
1
1.5
time
r
e
t
u
r
n
10 20 30 40
0.5
0
0.5
1
1.5
time
r
e
t
u
r
n
(Market premium = 8%, market volatility = 25%, asset volatility = 40%.)
Solid lines asset rturns. Dotted lines market returns.
Dashdot lines market component. Dashed lines idiosyncratic component.
We can decompose return and risk as follows:
r
i
r
F
=
systematic
component
..
iM
( r
M
r
F
) +
non-systematic
component
..

i
.
total
risk
..
Var[ r
i
] =
systematic
risk
..
2
iM
Var[ r
M
] +
non-systematic
risk
..
Var[
i
] .
Example. Systematic risk is only a part of return volatility.
Consider an asset with
annual volatility () of 40%
market beta of 1.2.
Suppose that the annual volatility of the market is 25%. What
percentage of the total volatility of the asset is attributable to
non-systematic risk?
(0.4)
2
= (1.2)
2
(0.25)
2
+Var[ ].
Var[ ] = 0.0700.
= 0.2645.
Non-systematic risk
Total risk
=
0.07
0.16
= 43.75%.
Example. Two assets with the same total risk can have very
dierent systematic risks.
Suppose that
M
= 20%.
Stock Business Market beta Residual variance
1 Steel 1.5 0.10
2 Software 0.5 0.18
What is the total variance of each return?
2
1
=
2
1M
2
M
+
2
1
= (1.5)
2
(0.2)
2
+0.10
= 0.19
2
2
=
2
2M
2
M
+
2
2
= (0.5)
2
(0.2)
2
+0.18
= 0.19.
However
R
2
1
=
(1.5)
2
(0.2)
2
0.19
= 47%
R
2
2
=
(0.5)
2
(0.2)
2
0.19
= 5%.
Alpha
r
i
r
F
=
i
+
iM
( r
M
r
F
) +
i
According to CAPM, should be zero for all assets.
measures an assets return in access of its risk-adjusted
award according to CAPM.
What to do with an asset of positive ?
Check estimation error.
Past value of may not predict its future value.
Positive may be compensating for other risks.
. . .
5 Applications of CAPM
Example. Required rates of return on IBM and Dell.
1. Use the value-weighted stock portfolio as a proxy for the
market portfolio.
2. Regress historic returns of IBM and Dell on the returns on the
value-weighted portfolio. Suppose the beta estimates are
IBM,VW
= 0.73 and
Dell,VW
= 1.63.
3. Use historic excess returns on the value weighted portfolio to
estimated average market premium:
= r
VW
r
F
= 8.6%.
4. Obtain the current riskless rate. Suppose it is
r
F
= 4%.
5. Applying CAPM:
r
IBM
= r
F
+
IBM,VW
( r
VW
r
F
)
= 0.04 +(0.73)(0.086) = 0.1028.
The expected rate of return on IBM (under CAPM) is 10.28%.
Similarly, the expected rate of return on Dell is 18.02%.
R
e
a
d
i
n
g
t
h
e
B
e
t
a
B
o
o
k
M
L
P
F
&
S
s
B
e
t
a
B
o
o
k
0
0
/
0
3
R
e
s
i
d
S
t
d
.
E
r
r
.
N
u
m
.
T
i
c
k
e
r
C
l
o
s
e
S
t
d
o
f
o
f
A
d
j
.
o
f
S
y
m
b
o
l
P
r
i
c
e
B
e
t
a
A
l
p
h
a
R
-
S
q
r
.
D
e
v
-
N
.
B
e
t
a
A
l
p
h
a
B
e
t
a
O
b
s
.
A
A
L
A
A
m
e
r
A
l
i
a
2
.
2
5
0
-
2
.
2
5
1
0
.
0
5
0
.
0
3
4
2
.
7
2
1
.
3
0
6
.
0
6
-
1
.
1
5
6
0
A
O
L
A
m
e
r
i
c
a
O
n
l
i
n
e
6
7
.
4
3
8
2
.
4
0
4
.
1
2
0
.
2
5
1
7
.
1
7
0
.
5
2
2
.
4
4
1
.
9
3
6
0
G
N
L
K
G
e
n
e
L
i
n
k
0
.
2
9
0
-
7
.
7
4
1
6
.
1
5
0
.
4
4
3
7
.
3
0
2
.
1
0
9
.
9
2
-
4
.
7
9
1
7
G
M
G
e
n
e
r
a
l
M
t
r
s
8
2
.
8
1
3
1
.
0
1
-
0
.
5
7
0
.
2
7
6
.
9
8
0
.
2
1
0
.
9
9
1
.
0
1
6
0
T
S
N
T
y
s
o
n
F
o
o
d
s
1
1
.
1
2
5
1
.
1
3
-
2
.
3
1
0
.
2
3
8
.
5
5
0
.
2
6
1
.
2
1
1
.
0
9
6
0
N
o
t
e
:
(
a
)
S
&
P
5
0
0
i
s
u
s
e
d
a
s
a
p
r
o
x
y
f
o
r
t
h
e
m
a
r
k
e
t
.
(
b
)
B
e
t
a
s
a
r
e
e
s
t
i
m
a
t
e
d
w
i
t
h
r
a
w
r
e
t
u
r
n
s
,
n
o
t
r
i
s
k
r
i
s
k
p
r
e
m
i
u
m
s
.
T
h
e
a
l
p
h
a
,
a
c
c
o
r
d
i
n
g
t
o
C
A
P
M
,
i
s
r
F
(
1
)
.
(
c
)
A
d
j
u
s
t
e
d
b
e
t
a
i
s
o
b
t
a
i
n
e
d
u
s
i
n
g
o
t
h
e
r
i
n
f
o
r
m
a
t
i
o
n
.
6 Empirical Evaluation of CAPM
1. Long-run average returns are signicantly related to beta:
(Source: Fisher Black, Beta and return.)
The dots show the actual average risk premiums from portfolios with
dierent betas.
high beta portfolios generated higher average returns
high beta portfolios fall below SML
low beta portfolios land above SML
a line tted to the 10 portfolios would be atter than SML.
2. CAPM does not seem to work well over the last 30 years:
Source: Fischer Black, Beta and return.
The dots show the actual average risk premiums from portfolios with
dierent betas over dierent periods. The relation between beta and
actual average return has been much weaker since the mid-1960s.
3. Factors other than beta seem important in pricing assets:
Source: G. Fama and K. French, The Cross-Section of Expected Stock Returns.
Since mid-1960s:
Small stocks have outperformed large stocks
Stocks with low ratios of market-to-book value have outper-
formed stocks with high ratios.
7 Summary of CAPM
CAPM is attractive:
1. It is simple and sensible:
is built on modern portfolio theory
distinguishes systematic risk and non-systematic risk
provides a simple pricing model.
2. It is relatively easy to implement.
CAPM is controversial:
1. It is dicult to test:
dicult to identify the market portfolio
dicult to estimate returns and betas.
2. Empirical evidence is mixed.
3. Alternative pricing models might do better.
Multi-factor CAPM.
Consumption CAPM (C-CAPM).
APT.
8 Appendix A: Capital Market Line
In the presence of a risk-free asset, all ecient frontier portfolios lie on the
Capital Market Line (CML):
Capital Market Line (CML)
-
6
E[ r]
m
r
F
r
m
r
p
CML
v
m
` ` ` ` ` ` ` ` ` ` ` ` ` ` ` `
`
`
`
`
`
`
`
`
`
`
`
`
`
s
_
_
r
m
r
F
Investors hold only portfolios on CML
The risk of an ecient frontier portfolio is its StD
CML gives the trade-o between portfolio risk and return
The price of one unit risk for an ecient portfolio is
E[ r
m
] r
F
m
[the risk premium on market portfolio per unit of its StD].
9 Appendix B: Extensions of CAPM
9.1 Multifactor CAPM
In CAPM, investors care about returns on their investments over the next short
horizon they follow myopic investment strategies.
Myopic strategy is optimal if
1. Investors have only short horizons, or
2. Investors asset demand does not change over time
future returns same as today:
the same r
F
, r
m
r
F
,
m
,
im
(i = 1, . . . , n)
investors risk preferences same as today.
Thus, even if investors actually invest for a long horizon, CAPM may work
when future investment opportunities are the same as today.
In practice, however:
Investors do invest over long horizons
Investment opportunities do change over time.
Thus
Investors may worry about unfavorable shifts in future investment oppor-
tunities.
They may accept lower expected returns on assets that help to hedge
against such shifts.
Example. Graduating MBAs saving for retirement may worry about a fall in
future real interest rates.
They might not be content with holding the market portfolio and the
riskless asset.
They might overweight assets that do well if real interest rates fall.
They would be willing to accept low returns on these assets (relative to
CAPM predictions).
How does this work?
1. In order to hedge the interest rate risk, construct a portfolio q that is
uncorrelated with the market but highly correlated with changes in real
interest rates.
2. The optimal portfolio now consists of three funds three-fund separa-
tion:
riskless asset
market portfolio
hedging portfolio q.
3. In equilibrium, an assets premium is given by a multi-factor CAPM:
r
i
r
F
=
im
( r
m
r
F
) +
iq
_
r
q
r
F
_
.
In general, there are two types of systematic risks:
1. Static (temporal) Market risk
2. Dynamic (intertemporal) Changes in investment opportunities.
Investors demand to be rewarded for bearing both types of risks.
Multi-factor CAPM tries to model the two types of systematic risk and how
these risks are priced:
Identify macroeconomic variables, the factors, that might aect invest-
ment opportunities.
Find portfolios of traded securities that are highly correlated with these
factors.
Hypothesize that the risk premium on an asset is linearly related to the
risk premium on these portfolios:
r
i
r
F
=
i
+
i1
_
r
f1
r
F
_
+. . . +
iK
_
r
fK
r
F
_
.
where r
fk
is the return on the portfolio that is correlated with only the
k-th factor.
The factor betas can be estimated using regression analysis, as in the case
of CAPM.
Advantages of multi-factor CAPM:
Model captures dierent types of systematic risk
(a) temporal
(b) intertemporal.
Model has the potential to t data better.
Weaknesses of multi-factor CAPM:
Model does may not identify the macroeconomic variables that constitute
intertemporal risks.
Model does may not specify the relative importance of these intertemporal
risks.
9.2 Consumption CAPM (CCAPM)
To use the multifactor CAPM, we need to identify dierent sources of intertem-
poral risks in asset returns and specify their relative importance to investors.
The theory itself gives little information on these factors and the data we have
may not provide sucient information either.
However, there is another way to characterize how investors perceive the risk
in asset returns a way that allows us to collapse many risk factors into one.
Consider a representative investor who decides between how much to invest in
each asset:
She faces the following choices:
1. Consume $1 today
achieve utility u
0
(c
0
), or
2. Invest the $1 in asset i
receive $(1 + r
i
) tomorrow
consume the payo, and achieve utility u
1
(c
1
)(1 + r
i
).
At optimum, she should be indierent between choice 1 and 2.
If 1 is better, sell asset i and consume today.
If 2 is better, cut consumption today and invest in asset i.
Thus, at the optimum:
u
0
(c
0
) = E
_
u
1
(c
1
)(1 + r
i
)
.
In particular, for the risk-free asset:
u
0
(c
0
) = E
_
u
1
(c
1
)(1 +r
F
)
.
Take the dierence between the two equations:
E
_
u
1
(c
1
) ( r
i
r
F
)
= 0.
Observation: For two random variables x and y,
E[ x y] = Cov[ x, y] + x y.
Thus
r
i
r
F
=
1
E
_
u
1
(c
1
)
Cov
_
u
1
(c
1
), r
i
.
An assets risk premium is negatively related to the covariance between its
return and an investors future marginal utility.
Observation: The above must be true for any investor who is at optimum.
(a) For Cov
_
u
1
(c
1
), r
i
> 0
asset i pays when future marginal utility money is high
its payo is more valuable
it commands negative premium.
(b) For Cov
_
u
1
(c
1
), r
i
< 0
asset i pays when future marginal utility of money is low
its payo is less valuable
it commands positive premium.
Thus, an assets risk is measured by the covariance between its return and
investors marginal utility.
More generally, we have
E
t
[ r
it+1
] r
Ft
=
1
E
t
_
u
1
(c
t+1
)
Cov
t
_
u
t+1
(c
t+1
), r
it+1
.
This is the Consumption CAPM.
Advantages of CCAPM:
It gives the most general theory of risk.
There is really only one risk the risk in future consumption.
Weaknesses of CCAPM:
Theory itself does not specify investors marginal utilities.
Implementation relies on consumption data, which is lacking.
Theory relies on rationality of individual investors.
10 Homework
Readings:
BKM Chapters 9.
BM Chapters 8.2, 8.3.
Readings package: Beta and return (F. Black).
Assignment:
Problem Set 8.
Project 2 on equity portfolio management.

55 Notes On Capm

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

55 Notes On Capm

Uploaded by

Copyright:

Available Formats

Chapter 11

Capital Asset Pricing Model

You might also like