Lecture 6

The CAPM

Learning outcomes
By the end of this lecture you should:
Be able to interpret and apply the CAPM, both for
individual assets and portfolios
Know what the assumptions of the CAPM is why
they are relevant
Know how to partition the risk of an asset into a
systematic and an unsystematic part, and why it is
important

Quick recap
Last lecture we saw how the separation
theorem implies all investors hold the same
optimal risky portfolio, P*
In equilibrium, the demand for risky assets
must equal the supply of risky assets
Therefore the optimal risky portfolio must
equal the market portfolio, M
The properties of a risky asset in that portfolio
will determine how attractive it is
3

Quick recap
The relevant properties of our combined
portfolio is its risk and expected return
If we combine several assets, some risk may
be diversified away
How much of an assets risk can be diversified
away and how much cannot depends on its
covariance with the other assets in the
portfolio
4

Quick recap
Last lecture, we derived an expression for the
relation between the covariance of an assets
returns with the market and the required
return of the asset:
E (ri ) = rf +

Cov(ri , rM )

2
M

[E (r ) r ]
M

We call this expression the Capital Asset

Pricing Model, or the CAPM
5

Interpretation of the CAPM

E (ri ) = rf +

Cov(ri , rM )

2
M

[E (r ) r ]
M

On the LHS we have the expected return of the

asset
We typically refer to this as the required return
It is the return required by the market to
compensate for the relevant risk of the asset
In equilibrium no asset is better than some
other asset. Each asset is exactly compensated
for its risk.
6

Two special cases of the CAPM

For the market portfolio M itself, the CAPM
simplifies to:
Cov (r , r )
E (rM ) = r f +

M2

[E (r ) r ]
M

M2
E (rM ) = r f + 2 [E (rM ) r f ] = r f + E (rM ) rf
M
E (rM ) = E (rM )

For the risk free asset the CAPM simplifies to:

E (r f ) = r f +
E (r f ) = rf +
E (rf ) = rf

Cov (r f , rM )

M2
0

M2

[E (r ) r ]
M

[E (r ) r ]
M

Two special cases of the CAPM

For M and f the CAPM is simply an identity
Their expected returns are set by the specific
preference of people that trade in the market
These are very hard to figure out and well
take the properties of M and f as given
(exogenous)
Once we know these, the CAPM will tell us
how any other asset are priced in relation to
them
8

Interpretation of the CAPM

E (ri ) = rf +

Cov(ri , rM )

M2

[E (r ) r ]
M

In particular, we take the expected excess return of the

market, E(rM)-rf, as given
We often refer to this expected excess return as the
market risk premium
This is the reward we can expect to get for taking on
the risk of the market portfolio
Recall that the covariance of an asset with the market
portfolio measures how much risk the asset
contributes
9

The Security Market Line

We can illustrate this in a graph similar to the CAL

Each asset is compensated with excess return in relation to its risk in the
market portfolio
We often denote the risk ratio in the CAPM with i
According to the CAPM, all assets plot on a straight line between f and M
in - E(r) space
We call this line the Security Market Line, SML
E (ri )

SML

rf
i =

Cov(ri , rM )

M2

10


An assets measures how much risk the
assets contributes in the market portfolio,
relative to the average contribution
i > 1 means that Cov(ri, rM) > Var(rM), or that
the asset contributes more risk than the
average asset
i < 1 means that Cov(ri, rM) < Var(rM), or that
the asset contributes less risk than the
average asset
11

The Security Market Line

Since nobody likes risk, investors will demand higher returns of assets that
contribute more risk in the portfolio
We can interpret the SML much like we interpreted the CAL:
An asset with = 0.5 contributes half the risk of the average asset and gets half the
reward in terms of excess returns
An asset with = 2 contributes twice the risk of the average asset and gets twice the
reward in terms of excess returns

E (ri )

SML

rf
i =

Cov(ri , rM )

M2

12

A regression formulation
Although the CAPM tells us the expected return of
an asset, we know that realized returns may be
higher or lower than that
It is useful to phrase the CAPM as a regression
model, in which we relate realized returns to each
other and allow for some random error, :
ri = rf + i (rM rf ) +

Well make the usual assumption on , e.g. that it is

normally distributed around zero and uncorrelated
with the dependent variables, i.e. rM
13

A regression formulation
Recall from statistics, the univariate OLS regression model:
Y = + X +

The value of is

Cov( X , Y )
Var ( X )

In our case, X = rM rf and Y = ri and = rf:

=

Cov (ri , rM rf )
Var (rM rf )

ri =rf +

Cov(ri , rM )
Var (rM )

Cov ( ri , rM )

rM rf +
Var ( rM )

This is the CAPM expression that we derived last lecture

14

A regression formulation
We see that by taking expectations on both sides we can return to
our previous formula: r = r + [r r ]+
E (r ) = E (r + [r r ]+ )
E (r ) = E (r ) + [E (r ) E (r )]+ E ( )
i

E (ri ) = rf + i E (rM ) rf + 0

Given this formulation, we can calculate the risk of an asset by

taking the variance on both sides:

ri = rf + i rM rf +

]
Var (r ) = Var ( [r r ] + )
Var (r ) = Var (r r ) + Var ( ) + 2 Cov (r
Var (ri ) = Var (rf + i rM rf + )
i
i

2
i

rf , )

The second step follows as rf is a constant and the third step is

applying our usual manipulations of variances

15

A regression formulation
Since rf is still a constant, we can simplify the
expression further:
Var (ri ) = i2Var (rM rf ) + Var ( ) + 2 Cov (rM rf , )
Var (ri ) = i2Var (rM ) + Var ( ) + 2 Cov(rM , )

Finally, lets note that since is uncorrelated

to rM, the last term equals zero:
Var (ri ) = i2Var (rM ) + Var ( )

i2 = i2 M2 + 2

We see that variance of an asset can be

partitioned into two parts
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Systematic risk
i2 = i2 M2 + 2

The first term in the expression is called

systematic risk or market risk
Recall that is a measure of an assets covariance
with the market
The systematic risk is the part of an assets risk
that is common with the market
Since this risk is common with the market it
cannot be diversified away in the market portfolio
17

Example
Suppose we run some industrial firm. Many
things could affect our returns.
For instance, there could be an oil embargo or
an earth quake
These events would affect all firms, so we say
that these risks are systematic
Since all firms are affected, their returns
would move together in this situation
Therefore we cannot diversify the risk away
18

Unsystematic risk
i2 = i2 M2 + 2

The second term in the expression is called

unsystematic risk or idiosyncratic risk
The unsystematic risk is the part of an assets
risk that is particular to the asset itself
Since this risk comes from sources that do not
affect the market it can be diversified away in
the market portfolio
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Example
Suppose that we step on a nail and cannot work
or that an accidental fire burns our plant down
This would be bad for our returns, but other firms
would not be affected
We call these risks unsystematic
Since other firms are unaffected, we could
diversify such risks away by combining many
stocks in a portfolio
It is unlikely that everyone steps on a nail the
same day
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Implications of the CAPM

The CAPM basically states that only systematic
risk is priced
You are not compensated for taking on
unsystematic risk (which can be diversified away
anyway)
Unsystematic risk hurts as much as systematic
risk unless its diversified away
The implication is that we should always welldiversified portfolios
It is very hard to beat the market, but it is very
easy to lose to it
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The SML and the CAL

The SML and the CAL are similar in that they
relate expected returns to risk measures
Individual assets will typically plot under the
CAL, as it relates expected returns to total risk,
which typically includes some (unpriced)
unsystematic part
All assets will plot on the SML, as it relates
expected returns to (priced) systematic risk
only
22

The SML and the CAL

We can see the two types of risk in a graph of the
CAL
The risk of an asset left of the CAL is systematic
The risk of an asset right of the CAL is unsystematic
(and earns no extra expected return)
E (ri )
Systematic risk

CAL

P*
A

rf

Unsystematic risk

23

The market portfolio

Recall that the in equilibrium the market
portfolio is the optimal risky portfolio
By construction, all risk in M is common with
itself (the market)
There is no unsystematic risk in M = P* as seen
in the last graph
There is no unsystematic risk in any portfolio
on the CAL, i.e. when on the CAL we get paid
for all the risk we take
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The market portfolio

If we interpret the as the systematic risk of
an asset relative to that of the market, it is
obvious that the market portfolio must be
one
Cov(r , r )
=
=
=1

Mathematically:

M
2
M

2
M
2
M

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Portfolio
The of a portfolio is the weighted average of
the of the assets in that portfolio
Consider the portfolio P: r = w r + w r
We manipulate both sides to get the :
P

Cov(rP , rM )

2
M

1 1

2 2

Cov(w1r1 + w2 r2 , rM )

M2

To calculate Cov(w1r1 + w2r2, rM), we set up the

covariance matrix:
rM
w 1r1

Cov(w1r1,rM)

w2r2

Cov(w2r2,rM)

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Portfolio
We see that
Cov(w1r1 + w2 r2 , rM ) = Cov(w1r1 , rM ) + Cov(w2 r2 , rM ) = w1Cov(r1 , rM ) + w2Cov(r1 , rM )

Substituting:
P =

Cov (rP , rM )

2
M

w1Cov (r1 , rM )

2
M

w2Cov(r1 , rM )

2
M

= w11 + w2 2

Since the market portfolio consists of all assets

on the market and has = 1, the (value
weighted) average beta on the market is one
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Assumptions of CAPM
Investors are price takers
No investor is large enough relative to the market to
influence equilibrium prices by her trades

Investors have identical investment horizons and

agree on the statistical properties of all assets
All investors agree on expected returns and
covariances of all assets

Perfect capital markets

There are no financial frictions such as short selling
constraints, transaction costs, taxes etc.
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Assumptions of CAPM
Investors are rational mean-variance
optimizers
All investors maximize a utility function somewhat
like ours and do so correctly

There is a risk free asset available to all

All investors can borrow and invest in this at the
same rate

All investors can trade all assets

We disregard assets such as human capital
29

Using the CAPM

The CAPM has implications for our portfolio
choice, e.g. avoid unsystematic risk
The CAPM allows us to evaluate investment
performance by relating returns to the priced
risk taken
We can separate market effects from
unsystematic effects
We can use the CAPM to calculate required
returns for non-traded assets or firm projects
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