LecLure 6

1he CAM
Learnlng ouLcomes
8y Lhe end of Lhls lecLure you should:
8e able Lo lnLerpreL and apply Lhe CAM, boLh for
lndlvldual asseLs and porLfollos
know whaL Lhe assumpLlons of Lhe CAM ls why
Lhey are relevanL
know how Lo parLlLlon Lhe rlsk of an asseL lnLo a
sysLemaLlc and an unsysLemaLlc parL, and why lL ls
lmporLanL
2
Culck recap
LasL lecLure we saw how Lhe separaLlon
Lheorem lmplles all lnvesLors hold Lhe same
opLlmal rlsky porLfollo, !
"
ln equlllbrlum, Lhe demand for rlsky asseLs
musL equal Lhe supply of rlsky asseLs
1herefore Lhe opLlmal rlsky porLfollo musL
equal Lhe markeL porLfollo, $
1he properLles of a rlsky asseL ln LhaL porLfollo
wlll deLermlne how aLLracLlve lL ls
3
Culck recap
1he relevanL properLles of our comblned
porLfollo ls lLs rlsk and expecLed reLurn
lf we comblne several asseLs, some rlsk may
be dlverslfled away
Pow much of an asseL's rlsk can be dlverslfled
away and how much cannoL depends on lLs
covarlance wlLh Lhe oLher asseLs ln Lhe
porLfollo

4
Culck recap
LasL lecLure, we derlved an expresslon for Lhe
relaLlon beLween Lhe covarlance of an asseLs
reLurns wlLh Lhe markeL and Lhe requlred
reLurn of Lhe asseL:


We call Lhls expresslon Lhe %&'()&* +,,-)
!.(/(01 $23-*, or Lhe !"#$
( )
( )
( ) | |
f M
M
M i
f i
r r E
r r Cov
r r E + =
2
,
o
3
lnLerpreLaLlon of Lhe CAM

Cn Lhe LPS we have Lhe expecLed reLurn of Lhe
asseL
We Lyplcally refer Lo Lhls as Lhe .-45(.-3 .-)5.0
lL ls Lhe reLurn requlred by Lhe markeL Lo
compensaLe for Lhe relevanL rlsk of Lhe asseL
ln equlllbrlum no asseL ls beLLer" Lhan some
oLher asseL. Lach asseL ls exacLly compensaLed
for lLs rlsk.
( )
( )
( ) | |
f M
M
M i
f i
r r E
r r Cov
r r E + =
2
,
o
6
1wo speclal cases of Lhe CAM
lor Lhe markeL porLfollo $ lLself, Lhe CAM
slmpllfles Lo:


lor Lhe rlsk free asseL Lhe CAM slmpllfles Lo:
( )
( )
( ) | |
( ) ( ) | | ( )
( ) ( )
M M
f M f f M
M
M
f M
f M
M
M M
f M
r E r E
r r E r r r E r r E
r r E
r r Cov
r r E
=
+ = + =
+ =
2
2
2
,
o
o
o
( )
( )
( ) | |
( ) ( ) | |
( )
f f
f M
M
f f
f M
M
M f
f f
r r E
r r E r r E
r r E
r r Cov
r r E
=
+ =
+ =
2
2
0
,
o
o
7
1wo speclal cases of Lhe CAM
lor $ and 6 Lhe CAM ls slmply an ldenLlLy
1helr expecLed reLurns are seL by Lhe speclflc
preference of people LhaL Lrade ln Lhe markeL
1hese are very hard Lo flgure ouL and we'll
Lake Lhe properLles of $ and 6 as glven
(exogenous)
Cnce we know Lhese, Lhe CAM wlll Lell us
how any oLher asseL are prlced ln relaLlon Lo
Lhem
8
lnLerpreLaLlon of Lhe CAM


ln parLlcular, we Lake Lhe expecLed excess reLurn of Lhe
markeL, L(.
$
)-.
6
, as glven
We ofLen refer Lo Lhls expecLed excess reLurn as Lhe
markeL rlsk premlum
1hls ls Lhe reward we can expecL Lo geL for Laklng on
Lhe rlsk of Lhe markeL porLfollo
8ecall LhaL Lhe covarlance of an asseL wlLh Lhe markeL
porLfollo measures how much rlsk Lhe asseL
conLrlbuLes
( )
( )
( ) | |
f M
M
M i
f i
r r E
r r Cov
r r E + =
2
,
o
9
1he SecurlLy MarkeL Llne
We can lllusLraLe Lhls ln a graph slmllar Lo Lhe CAL
Lach asseL ls compensaLed wlLh excess reLurn ln relaLlon Lo lLs rlsk ln Lhe
markeL porLfollo
We ofLen denoLe Lhe rlsk raLlo ln Lhe CAM wlLh
i
Accordlng Lo Lhe CAM, all asseLs ploL on a sLralghL llne beLween 6 and $
ln - L(.) space
We call Lhls llne Lhe 7-/5.()8 $&.9-) :(0-, &$'
.
6
M

( )
2
,
M
M i
i
r r Cov
o
| =
( )
i
r E
SML

10

An asseL's measures how much rlsk Lhe
asseLs conLrlbuLes ln Lhe markeL porLfollo,
relaLlve Lo Lhe average conLrlbuLlon

l
> 1 means LhaL Cov(r
l
, r
M
) > var(r
M
), or LhaL
Lhe asseL conLrlbuLes more rlsk Lhan Lhe
average asseL

l
< 1 means LhaL Cov(r
l
, r
M
) < var(r
M
), or LhaL
Lhe asseL conLrlbuLes less rlsk Lhan Lhe
average asseL

11
1he SecurlLy MarkeL Llne
Slnce nobody llkes rlsk, lnvesLors wlll demand hlgher reLurns of asseLs LhaL
conLrlbuLe more rlsk ln Lhe porLfollo
We can lnLerpreL Lhe SML much llke we lnLerpreLed Lhe CAL:
An asseL wlLh = 0.3 conLrlbuLes half Lhe rlsk of Lhe average asseL and geLs half Lhe
reward ln Lerms of excess reLurns
An asseL wlLh = 2 conLrlbuLes Lwlce Lhe rlsk of Lhe average asseL and geLs Lwlce Lhe
reward ln Lerms of excess reLurns
.
6
M

( )
2
,
M
M i
i
r r Cov
o
| =
( )
i
r E
SML

12
A regresslon formulaLlon
AlLhough Lhe CAM Lells us Lhe expecLed reLurn of
an asseL, we know LhaL reallzed reLurns may be
hlgher or lower Lhan LhaL
lL ls useful Lo phrase Lhe CAM as a regresslon
model, ln whlch we relaLe reallzed reLurns Lo each
oLher and allow for some random error, :

We'll make Lhe usual assumpLlon on , e.g. LhaL lL ls
normally dlsLrlbuLed around zero and uncorrelaLed
wlLh Lhe dependenL varlables, l.e. .
$

( ) c | + + =
f M i f i
r r r r
13
A regresslon formulaLlon
8ecall from sLaLlsLlcs, Lhe unlvarlaLe CLS regresslon model:

1he value of ls

ln our case, ; = .
$
- .
6
and < = .
(
and = .
6
:





1hls ls Lhe CAM expresslon LhaL we derlved lasL lecLure
c | o + + = X Y
( )
( ) X Var
Y X Cov ,
= |
( )
( )
( )
( )
M
M i
f M
f M i
r Var
r r Cov
r r Var
r r r Cov
,
,
=

= |
14
( )
( )
,
i M
i f M f
M
Cov r r
r r r r
Var r
c ( = + +

A regresslon formulaLlon
We see LhaL by Laklng expecLaLlons on boLh sldes we can reLurn Lo
our prevlous formula:



Clven Lhls formulaLlon, we can calculaLe Lhe rlsk of an asseL by
Laklng Lhe varlance on boLh sldes:




1he second sLep follows as .
6
ls a consLanL and Lhe Lhlrd sLep ls
applylng our usual manlpulaLlons of varlances
| |
( ) | | ( )
( ) ( ) ( ) ( ) | | ( )
( ) ( ) | | 0 + + =
+ + =
+ + =
+ + =
f M i f i
f M i f i
f M i f i
f M i f i
r r E r r E
E r E r E r E r E
r r r E r E
r r r r
|
c |
c |
c |
| |
( ) | | ( )
( ) | | ( )
( ) ( ) ( ) ( ) c | c |
c |
c |
c |
, 2
2
f M i f M i i
f M i i
f M i f i
f M i f i
r r Cov Var r r Var r Var
r r Var r Var
r r r Var r Var
r r r r
+ + =
+ =
+ + =
+ + =
13
A regresslon formulaLlon
Slnce .
6
ls sLlll a consLanL, we can slmpllfy Lhe
expresslon furLher:

llnally, leL's noLe LhaL slnce ls uncorrelaLed
Lo .
$
, Lhe lasL Lerm equals zero:

We see LhaL varlance of an asseL can be
parLlLloned lnLo Lwo parLs


( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) c | c |
c | c |
, 2
, 2
2
2
M M i i
f M f M i i
r Cov Var r Var r Var
r r Cov Var r r Var r Var
+ + =
+ + =
( ) ( ) ( )
2 2 2 2
2
c
o o | o
c |
+ =
+ =
M i i
M i i
Var r Var r Var
16
SysLemaLlc rlsk

1he flrsL Lerm ln Lhe expresslon ls called
,8,)-=&)(/ .(,9 or =&.9-) .(,9
8ecall LhaL ls a measure of an asseLs covarlance
wlLh Lhe markeL
1he sysLemaLlc rlsk ls Lhe parL of an asseL's rlsk
LhaL ls common wlLh Lhe markeL
Slnce Lhls rlsk ls common wlLh Lhe markeL lL
cannoL be dlverslfled away ln Lhe markeL porLfollo
2 2 2 2
c
o o | o + =
M i i
17
Lxample
Suppose we run some lndusLrlal flrm. Many
Lhlngs could affecL our reLurns.
lor lnsLance, Lhere could be an oll embargo or
an earLh quake
1hese evenLs would affecL all flrms, so we say
LhaL Lhese rlsks are sysLemaLlc
Slnce all flrms are affecLed, Lhelr reLurns
would move LogeLher ln Lhls slLuaLlon
1herefore we cannoL dlverslfy Lhe rlsk away


18
unsysLemaLlc rlsk

1he second Lerm ln Lhe expresslon ls called
50,8,)-=&)(/ .(,9 or (3(2,80/.&)(/ .(,9
1he unsysLemaLlc rlsk ls Lhe parL of an asseL's
rlsk LhaL ls parLlcular Lo Lhe asseL lLself
Slnce Lhls rlsk comes from sources LhaL do noL
affecL Lhe markeL lL can be dlverslfled away ln
Lhe markeL porLfollo
2 2 2 2
c
o o | o + =
M i i
19
Lxample
Suppose LhaL we sLep on a nall and cannoL work
or LhaL an accldenLal flre burns our planL down
1hls would be bad for our reLurns, buL oLher flrms
would noL be affecLed
We call Lhese rlsks unsysLemaLlc
Slnce oLher flrms are unaffecLed, we could
dlverslfy such rlsks away by comblnlng many
sLocks ln a porLfollo
lL ls unllkely LhaL everyone sLeps on a nall Lhe
same day


20
lmpllcaLlons of Lhe CAM
1he CAM baslcally sLaLes LhaL only sysLemaLlc
rlsk ls prlced
?ou are noL compensaLed for Laklng on
unsysLemaLlc rlsk (whlch can be dlverslfled away
anyway)
unsysLemaLlc rlsk hurLs as much as sysLemaLlc
rlsk unless lL's dlverslfled away
1he lmpllcaLlon ls LhaL we should always well-
dlverslfled porLfollos
lL ls very hard Lo beaL Lhe markeL, buL lL ls very
easy Lo lose Lo lL
21
1he SML and Lhe CAL
1he SML and Lhe CAL are slmllar ln LhaL Lhey
relaLe expecLed reLurns Lo rlsk measures
lndlvldual asseLs wlll Lyplcally ploL under Lhe
CAL, as lL relaLes expecLed reLurns Lo LoLal rlsk,
whlch Lyplcally lncludes some (unprlced)
unsysLemaLlc parL
All asseLs wlll ploL on Lhe SML, as lL relaLes
expecLed reLurns Lo (prlced) sysLemaLlc rlsk
only
22
1he SML and Lhe CAL
We can see Lhe Lwo Lypes of rlsk ln a graph of Lhe
CAL
1he rlsk of an asseL lefL of Lhe CAL ls sysLemaLlc
1he rlsk of an asseL rlghL of Lhe CAL ls unsysLemaLlc
(and earns no exLra expecLed reLurn)

.
6
( )
i
r E
CAL

A
o
o

*
A

Systematic risk

Unsystematic risk

23
1he markeL porLfollo
8ecall LhaL Lhe ln equlllbrlum Lhe markeL
porLfollo ls Lhe opLlmal rlsky porLfollo
8y consLrucLlon, all rlsk ln $ ls common wlLh
lLself (Lhe markeL)
1here ls no unsysLemaLlc rlsk ln $ = !
"
as seen
ln Lhe lasL graph
1here ls no unsysLemaLlc rlsk ln any porLfollo
on Lhe CAL, l.e. when on Lhe CAL we geL pald
for all Lhe rlsk we Lake
24
1he markeL porLfollo
lf we lnLerpreL Lhe as Lhe sysLemaLlc rlsk of
an asseL relaLlve Lo LhaL of Lhe markeL, lL ls
obvlous LhaL Lhe markeL porLfollo musL be
one
MaLhemaLlcally:
( )
1
,
2
2
2
= = =
M
M
M
M M
M
r r Cov
o
o
o
|
23
orLfollo
1he of a porLfollo ls Lhe welghLed average of
Lhe of Lhe asseLs ln LhaL porLfollo
Conslder Lhe porLfollo :
We manlpulaLe boLh sldes Lo geL Lhe :

1o calculaLe Cov(>
?
.
?
+ >
@
.
@
, .
$
), we seL up Lhe
covarlance maLrlx:

( ) ( )
2
2 2 1 1
2
, ,
M
M
M
M P
r r w r w Cov r r Cov
o o
+
=
2 2 1 1
r w r w r
P
+ =
r
M

w
1
r
1
Cov(w
1
r
1
,r
M
)
w
2
r
2
Cov(w
2
r
2
,r
M
)
26
orLfollo
We see LhaL

SubsLlLuLlng:


Slnce Lhe markeL porLfollo conslsLs of all asseLs
on Lhe markeL and has = 1, Lhe (value
welghLed) average beLa on Lhe markeL ls one
( ) ( ) ( ) ( ) ( )
M M M M M
r r Cov w r r Cov w r r w Cov r r w Cov r r w r w Cov , , , , ,
1 2 1 1 2 2 1 1 2 2 1 1
+ = + = +
( ) ( ) ( )
2 2 1 1
2
1 2
2
1 1
2
, , ,
| |
o o o
| w w
r r Cov w r r Cov w r r Cov
M
M
M
M
M
M P
P
+ = + = =
27
AssumpLlons of CAM
lnvesLors are prlce Lakers
no lnvesLor ls large enough relaLlve Lo Lhe markeL Lo
lnfluence equlllbrlum prlces by her Lrades
lnvesLors have ldenLlcal lnvesLmenL horlzons and
agree on Lhe sLaLlsLlcal properLles of all asseLs
All lnvesLors agree on expecLed reLurns and
covarlances of all asseLs
erfecL caplLal markeLs
1here are no flnanclal frlcLlons such as shorL selllng
consLralnLs, LransacLlon cosLs, Laxes eLc.

28
AssumpLlons of CAM
lnvesLors are raLlonal mean-varlance
opLlmlzers
All lnvesLors maxlmlze a uLlllLy funcLlon somewhaL
llke ours and do so correcLly
1here ls a rlsk free asseL avallable Lo all
All lnvesLors can borrow and lnvesL ln Lhls aL Lhe
same raLe
All lnvesLors can Lrade all asseLs
We dlsregard asseLs such as human caplLal

29
uslng Lhe CAM
1he CAM has lmpllcaLlons for our porLfollo
cholce, e.g. avold unsysLemaLlc rlsk
1he CAM allows us Lo evaluaLe lnvesLmenL
performance by relaLlng reLurns Lo Lhe prlced
rlsk Laken
We can separaLe markeL effecLs from
unsysLemaLlc effecLs
We can use Lhe CAM Lo calculaLe requlred
reLurns for non-Lraded asseLs or flrm pro[ecLs
30