Chapter 11

Capital Asset Pricing Model
(CAPM)
Road Map
Part A Introduction to finance.
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 finance.
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 asset’s systematic risk is measured by contribution to the
risk of the tangent portfolio – its beta β
iT
.
4. An asset’s risk premium is proportional to its systematic risk:
¯ r
i
−r
F
= β
iT
(¯ r
T
−r
F
) .
Identifying the tangent portfolio gives a pricing model.
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-4 Capital Asset Pricing Model (CAPM) Chapter 11
2 The Market Portfolio
Definition: The market portfolio is the portfolio of all risky assets
traded in the market.
Definition: The market capitalization of an asset is its total
market value.
Suppose there are a total of i = 1, . . . , n risky assets. Asset i’s
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
.
15.407 Lecture Notes Fall 2003 c Jiang Wang
Chapter 11 Capital Asset Pricing Model (CAPM) 11-5
3 Derivation of CAPM
Assumptions for this chapter:
1. Investors agree on the distribution of asset returns.
2. Investors have the same fixed (static) investment horizon.
3. Investors hold efficient 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.
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-6 Capital Asset Pricing Model (CAPM) Chapter 11
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
.
15.407 Lecture Notes Fall 2003 c Jiang Wang
Chapter 11 Capital Asset Pricing Model (CAPM) 11-7
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
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-8 Capital Asset Pricing Model (CAPM) Chapter 11
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!
15.407 Lecture Notes Fall 2003 c Jiang Wang
Chapter 11 Capital Asset Pricing Model (CAPM) 11-9
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 diversified away.
• Bearing systematic risk needs to be rewarded.
5. The part of an asset’s risk that is not correlated with the
market portfolio, the non-systematic risk, can be diversified
away by holding a frontier portfolio.
• Bearing nonsystematic risk need not be rewarded.
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-10 Capital Asset Pricing Model (CAPM) Chapter 11
6. For any asset i:
E[˜ r
i
] −r
F
= β
iM
(E[˜ r
M
] −r
F
) (11.1)
where β
iM
= σ
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 asset’s risk premium and its market beta
is called the “Security Market Line” (SML).
Security Market Line (SML)
E
T
β
E[˜ r]
β
M
=1
r
F
¯ r
M
¯ r
i
β
i
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
SML
v
M
` ` ` ` ` ` ` ` ` ` ` ` ` ` ` `
`
`
`
`
`
`
`
`
`
`
`
`
`
s

¯ r
M
−r
F
15.407 Lecture Notes Fall 2003 c Jiang Wang
Chapter 11 Capital Asset Pricing Model (CAPM) 11-11
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 β = 0?
Answer: Same as the risk-free rate, 5%. Note:
• The stock may have significant uncertainty in its return.
• This uncertainty is uncorrelated with the market return.
2. What should be the expected return on a stock with β = 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 β = −0.6?
Answer: The expected return should be
¯ r = 0.05 +(−0.6)(0.14 −0.05) = −0.4%.
How can this be?
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-12 Capital Asset Pricing Model (CAPM) Chapter 11
4 Understanding Risk in CAPM
In CAPM, we can decompose an asset’s return into three pieces:
˜ r
i
−r
F
= α
i

iM
(˜ r
M
−r
F
) + ˜ ε
i
where
• E[˜ ε
i
] = 0
• Cov[˜ r
M
, ˜ ε
i
] = 0.
Three characteristics of an asset:
• Beta.
• Sigma = StD (˜ ε
i
).
• Alpha.
15.407 Lecture Notes Fall 2003 c Jiang Wang
Chapter 11 Capital Asset Pricing Model (CAPM) 11-13
Beta
˜ r
i
−r
F
= α
i
+ β
iM
(˜ r
M
−r
F
) + ˜ ε
i
• Beta measures an asset’s systematic risk.
• Assets with higher betas are more sensitive to the market.
Two assets with same total volatility but different 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.
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-14 Capital Asset Pricing Model (CAPM) Chapter 11
Sigma
˜ r
i
−r
F
= α
i

iM
(˜ r
M
−r
F
) + ˜ ε
i
• An asset’s sigma measures its non-systematic risk.
• Non-systematic risk is uncorrelated with systematic risk.
Two assets with same total volatility but different 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.
15.407 Lecture Notes Fall 2003 c Jiang Wang
Chapter 11 Capital Asset Pricing Model (CAPM) 11-15
We can decompose return and risk as follows:
˜ r
i
−r
F
=
systematic
component
. .. .
β
iM
(˜ r
M
−r
F
) +
non-systematic
component
. .. .
˜ ε
i
.
total
risk
. .. .
Var[˜ r
i
] =
systematic
risk
. .. .
β
2
iM
Var[˜ r
M
] +
non-systematic
risk
. .. .
Var[˜ ε
i
] .
Example. Systematic risk is only a part of return volatility.
Consider an asset with
• annual volatility (σ) 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[˜ ε].
Var[˜ ε] = 0.0700.
σ
ε
= 0.2645.
Non-systematic risk
Total risk
=
0.07
0.16
= 43.75%.
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-16 Capital Asset Pricing Model (CAPM) Chapter 11
Example. Two assets with the same total risk can have very
different systematic risks.
Suppose that σ
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?
σ
2
1
= β
2
1M
σ
2
M

2

= (1.5)
2
(0.2)
2
+0.10
= 0.19
σ
2
2
= β
2
2M
σ
2
M

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%.
15.407 Lecture Notes Fall 2003 c Jiang Wang
Chapter 11 Capital Asset Pricing Model (CAPM) 11-17
Alpha
˜ r
i
−r
F
= α
i

iM
(˜ r
M
−r
F
) + ˜ ε
i
• According to CAPM, α should be zero for all assets.
• α measures an asset’s return in access of its risk-adjusted
award according to CAPM.
What to do with an asset of positive α?
• Check estimation error.
• Past value of α may not predict its future value.
• Positive α may be compensating for other risks.
• . . .
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-18 Capital Asset Pricing Model (CAPM) Chapter 11
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
β
IBM,VW
= 0.73 and β
Dell,VW
= 1.63.
3. Use historic excess returns on the value weighted portfolio to
estimated average market premium:
π = ¯ 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%.
15.407 Lecture Notes Fall 2003 c Jiang Wang
Chapter 11 Capital Asset Pricing Model (CAPM) 11-19
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c Jiang Wang Fall 2003 15.407 Lecture Notes
11-20 Capital Asset Pricing Model (CAPM) Chapter 11
6 Empirical Evaluation of CAPM
1. Long-run average returns are significantly related to beta:
(Source: Fisher Black, “Beta and return.”)
The dots show the actual average risk premiums from portfolios with
different betas.
• high beta portfolios generated higher average returns
• high beta portfolios fall below SML
• low beta portfolios land above SML
• a line fitted to the 10 portfolios would be flatter than SML.
15.407 Lecture Notes Fall 2003 c Jiang Wang
Chapter 11 Capital Asset Pricing Model (CAPM) 11-21
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
different betas over different periods. The relation between beta and
actual average return has been much weaker since the mid-1960s.
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-22 Capital Asset Pricing Model (CAPM) Chapter 11
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.
15.407 Lecture Notes Fall 2003 c Jiang Wang
Chapter 11 Capital Asset Pricing Model (CAPM) 11-23
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 difficult to test:
• difficult to identify the market portfolio
• difficult 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.
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-24 Capital Asset Pricing Model (CAPM) Chapter 11
8 Appendix A: Capital Market Line
In the presence of a risk-free asset, all efficient frontier portfolios lie on the
“Capital Market Line” (CML):
Capital Market Line (CML)
E
T
σ
E[˜ r]
σ
m
r
F
¯ r
m
¯ r
p
σ
p
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
¨
CML
v
m
` ` ` ` ` ` ` ` ` ` ` ` ` ` ` `
`
`
`
`
`
`
`
`
`
`
`
`
`
s

¯ r
m
−r
F
• Investors hold only portfolios on CML
• The risk of an efficient frontier portfolio is its StD
• CML gives the trade-off between portfolio risk and return
• The price of one unit risk for an efficient portfolio is
E[˜ r
m
] −r
F
σ
m
[the risk premium on market portfolio per unit of its StD].
15.407 Lecture Notes Fall 2003 c Jiang Wang
Chapter 11 Capital Asset Pricing Model (CAPM) 11-25
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
, σ
m
, β
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.
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-26 Capital Asset Pricing Model (CAPM) Chapter 11
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 asset’s premium is given by a multi-factor CAPM:
¯ r
i
−r
F
= β
im
(¯ r
m
−r
F
) +β
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:
15.407 Lecture Notes Fall 2003 c Jiang Wang
Chapter 11 Capital Asset Pricing Model (CAPM) 11-27
• Identify macroeconomic variables, the “factors”, that might affect 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
= α
i

i1

¯ r
f1
−r
F

+. . . +β
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 beta’s can be estimated using regression analysis, as in the case
of CAPM.
Advantages of multi-factor CAPM:
• Model captures different types of systematic risk
(a) temporal
(b) intertemporal.
• Model has the potential to fit 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.
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-28 Capital Asset Pricing Model (CAPM) Chapter 11
9.2 Consumption CAPM (CCAPM)
To use the multifactor CAPM, we need to identify different 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 sufficient 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 payoff, and achieve utility u

1
(˜c
1
)(1 +˜ r
i
).
At optimum, she should be indifferent 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
)

.
15.407 Lecture Notes Fall 2003 c Jiang Wang
Chapter 11 Capital Asset Pricing Model (CAPM) 11-29
Take the difference 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 asset’s risk premium is negatively related to the covariance between its
return and an investor’s 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 payoff 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 payoff is less valuable
• it commands positive premium.
Thus, an asset’s risk is measured by the covariance between its return and
investors’ marginal utility.
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-30 Capital Asset Pricing Model (CAPM) Chapter 11
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.
15.407 Lecture Notes Fall 2003 c Jiang Wang
Chapter 11 Capital Asset Pricing Model (CAPM) 11-31
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.
c Jiang Wang Fall 2003 15.407 Lecture Notes

11-2

Capital Asset Pricing Model (CAPM)

Chapter 11

Contents
1 2 3 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . 11-3 The Market Portfolio . . . . . . . . . . . . . . . . . . . . . . 11-4 Derivation of CAPM . . . . . . . . . . . . . . . . . . . . . . 11-5
3.1 3.2 3.3 A Numerical Illustration of CAPM . . . . . . . . . . . . . . . . . 11-6 A Formal Derivation of CAPM . . . . . . . . . . . . . . . . . . . 11-8 Implications of CAPM . . . . . . . . . . . . . . . . . . . . . . . . 11-9

4 5 6 7 8 9

Understanding Risk in CAPM . . . . . . . . . . . . . . . . . 11-12 Applications of CAPM . . . . . . . . . . . . . . . . . . . . . 11-18 Empirical Evaluation of CAPM . . . . . . . . . . . . . . . . . 11-20 Summary of CAPM . . . . . . . . . . . . . . . . . . . . . . . 11-23 Appendix A: Capital Market Line . . . . . . . . . . . . . . . 11-24 Appendix B: Extensions of CAPM . . . . . . . . . . . . . . . 11-25
9.1 9.2 Multifactor CAPM . . . . . . . . . . . . . . . . . . . . . . . . . 11-25 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
r E [˜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 asset’s systematic risk is measured by contribution to the risk of the tangent portfolio – its beta βiT. 4. An asset’s risk premium is proportional to its systematic risk:
r ri − rF = βiT (¯T − rF) . ¯

Identifying the tangent portfolio gives a pricing model.
c Jiang Wang Fall 2003 15.407 Lecture Notes

Definition: The market capitalization of an asset is its total market value. 15.407 Lecture Notes Fall 2003 c Jiang Wang . Suppose there are a total of i = 1. . . . The total market capitalization of all risky assets is n MCAPM = i=1 MCAPi. n risky assets.11-4 Capital Asset Pricing Model (CAPM) Chapter 11 2 The Market Portfolio Definition: The market portfolio is the portfolio of all risky assets traded in the market. . The market portfolio is the portfolio with weights in each risky asset i being wi = MCAPi MCAPi = . n MCAPj MCAPM j=1 We denote the market portfolio by wM. Asset i’s market capitalization is MCAPi = (price per share)i × (# of shares outstanding)i.

All investors hold the risky assets in same proportions • they hold the same risky portfolio. 5. Investors have the same fixed (static) investment horizon. Investors agree on the distribution of asset returns. c Jiang Wang Fall 2003 15. the tangent portfolio. 2. Investors hold efficient frontier portfolios. 3. 4. There is a risk-free asset: • paying interest rate rF • in zero net supply. The tangent portfolio is the market portfolio.Chapter 11 Capital Asset Pricing Model (CAPM) 11-5 3 Derivation of CAPM Assumptions for this chapter: 1. 3. Implications: 1. Demand of assets equals supply in equilibrium.407 Lecture Notes . Every investor puts their money into two pots: • the riskless asset • a single portfolio of risky assets – the tangent portfolio. 2.

There are only three investors in the economy. respectively. A. with total wealth of 500. wC ) = (0. 1000. Suppose that the tangent portfolio is wT = (wA .50. Their asset holdings (in billion dollars) are: Investor 1 2 3 Total Riskless 100 200 -300 0 A 100 200 450 750 B C 200 100 400 200 900 450 1500 750 Claim: The market portfolio is the tangent portfolio: wM = wT . B and C. 1. We show this through the example below. There are only three risky assets.11-6 Capital Asset Pricing Model (CAPM) Chapter 11 3. 0. 0. 1500 billion dollars.1 A Numerical Illustration of CAPM CAPM requires that in equilibrium total asset holdings of all investors must equal the total supply of assets. 2 and 3.25. 15.407 Lecture Notes Fall 2003 c Jiang Wang .25). wB .

50 1. The total market capitalization is 750 + 1500 + 750 = $3.0 8.00 0.0 6. The market portfolio is the tangent portfolio: wM = 750 1500 750 .25. 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.50.25) = wT .0 10. .0 9. per month) 3.00 3.Chapter 11 Capital Asset Pricing Model (CAPM) 11-7 In equilibrium.0 Standard Deviation (%.50 0.0 3.00 0.50 2.50 Efficiency frontier 4.00 1.00 T=M 2. 0. 4.50 Return (%.0 7.0 1. 3000 3000 3000 5.00 = (0.0 2.0 5.407 Lecture Notes . per month) c Jiang Wang Fall 2003 15. 000 billion.0 4. 0.

. the total wealth of investors equals the total value of stocks: wT = wM . The tangent portfolio is the market portfolio! 15. Market equilibrium — demand equals supply: 1. K investors.407 Lecture Notes Fall 2003 c Jiang Wang .11-8 Capital Asset Pricing Model (CAPM) Chapter 11 3. (2) Investor k has wealth Wk and invests in two funds: k • WF in riskless asset k • W k −WF in the tangent portfolio wT. all wealth is invested in stocks: K k=1 W k = MCAPM. 2. Money market equilibrium: K k=1 k WF = 0 (risk-free asset is in zero net supply) 2. Stock market equilibrium: K k=1 k W k −WF wT = MCAPM wM . . Since the net amount invested in the risk-free asset is zero. Thus. .2 A Formal Derivation of CAPM (1) There are k = 1. .

can be diversified away by holding a frontier portfolio. 4.3 Implications of CAPM 1. The risk of an individual asset is characterized by its covariability with the market portfolio. cannot be diversified away. 5. • Bearing systematic risk needs to be rewarded. the non-systematic risk. c Jiang Wang Fall 2003 15. The part of the risk that is correlated with the market portfolio. • Bearing nonsystematic risk need not be rewarded.Chapter 11 Capital Asset Pricing Model (CAPM) 11-9 3. 2.407 Lecture Notes . Combining the risk-free asset and the market portfolio gives the portfolio frontier. The market portfolio is the tangent portfolio. The part of an asset’s risk that is not correlated with the market portfolio. the systematic risk. 3.

The relation between an asset’s risk premium and its market beta is called the “Security Market Line” (SML).407 Lecture Notes Fall 2003 c Jiang Wang . the riskless rate and assets’ market betas. For any asset i: E[˜i] − rF = βiM (E[˜M] − rF) r r 2 where βiM = σiM/σM.11-10 Capital Asset Pricing Model (CAPM) Chapter 11 6.1) determines the premium of all assets. (11. Security Market Line (SML) E[˜] r T SML¨ ¨ M¨¨¨ v  ¨¨ ¨  ¨  ` ` ` ` ` ` ` ` ` ` ` ` ` ` ¨¨ s  ¨ ` ¨ ` ` rM − rF ¯ ¨¨ ¨ ` ¨  `  ¨¨ `  ¨ ` βi ` ` ` ` ` ` ¨ ¨¨ ¨ rM ¯ ri ¯ rF ` ` ¨¨ βM = 1 E β 15.1) Given the premium of market portfolio. We thus have an asset pricing model — the CAPM. equation (11.

• This uncertainty is uncorrelated with the market return.6)(0.6? Answer: The expected return should be r = 0.4%. 1. The expected market return is 14% and T-bill rate is 5%. Note: • The stock may have significant uncertainty in its return.5)(0. 2.05) = −0.05) + (0. ¯ 4. 5%. What should be expected return on stock with β = −0. 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. 3. What should be the expected return on a stock with β = 1? Answer: The same as the market return.14) = 9. Suppose that CAPM holds. ¯ How can this be? c Jiang Wang Fall 2003 15. What should be the expected return on a stock with β = 0? Answer: Same as the risk-free rate.Chapter 11 Capital Asset Pricing Model (CAPM) 11-11 Example.05 + (−0.407 Lecture Notes .5%. 14%.14 − 0.5)(0.

15. εi] = 0.11-12 Capital Asset Pricing Model (CAPM) Chapter 11 4 Understanding Risk in CAPM In CAPM. we can decompose an asset’s return into three pieces: r ˜ ri − rF = αi + βiM (˜M − rF) + εi ˜ where • E[˜i] = 0 ε • Cov[˜M. r ˜ Three characteristics of an asset: • Beta. • Sigma = StD (εi). ˜ • Alpha.407 Lecture Notes Fall 2003 c Jiang Wang .

2 (Market premium = 8%.) Solid lines – asset rturns.5 2 1.5 2 1.6 0.4 0. market volatility = 25%. c Jiang Wang Fall 2003 15.5 asset beta = 1.2 2 1. Two assets with same total volatility but different betas asset beta = 0.5 10 20 time 30 40 return 1 1 0.6 0.5 0 −0. • Assets with higher betas are more sensitive to the market.8 1 market return 1.5 0 −0.2 return 0.5 0 −0.Chapter 11 Capital Asset Pricing Model (CAPM) 11-13 Beta r ˜ ri − rF = αi + βiM (˜M − rF) + εi ˜ • Beta measures an asset’s systematic risk.2 asset return 1 0.5 0.8 1 market return 1.5 0 −0. Dotted lines – market returns.5 asset return 1 0. asset volatility = 40%.4 0.407 Lecture Notes .5 0.5 10 20 time 30 40 2 1.

Dashdot lines – market component. Dashed lines – idiosyncratic component. market volatility = 25%.5 0 −0. Dotted lines – market returns.5 10 20 time 30 40 1. • Non-systematic risk is uncorrelated with systematic risk.5 0 −0.5 1 1. 15.) Solid lines – asset rturns.5 1 asset beta = 1.5 10 20 time 30 40 return 0.5 0 −0.5 0 −0.5 1 1.407 Lecture Notes Fall 2003 c Jiang Wang .2 1.11-14 Capital Asset Pricing Model (CAPM) Chapter 11 Sigma r ri − rF = αi + βiM (˜M − rF) + εi ˜ ˜ • An asset’s sigma measures its non-systematic risk.5 10 20 time 30 40 return 0.5 1 return 0.5 10 20 time 30 40 (Market premium = 8%.2 return 0. Two assets with same total volatility but different betas asset beta = 0. asset volatility = 40%.

2645. What percentage of the total volatility of the asset is attributable to non-systematic risk? (0.07 = = 43.407 Lecture Notes . non-systematic risk Var[˜i] r = 2 βiMVar[˜M] r + Var[˜i] ε . ε σε = 0.4)2 = (1. Systematic risk is only a part of return volatility.0700. ε Var[˜] = 0. Suppose that the annual volatility of the market is 25%.75%. Non-systematic risk 0.25)2 + Var[˜].Chapter 11 Capital Asset Pricing Model (CAPM) 11-15 We can decompose return and risk as follows: systematic component non-systematic component ri − rF ˜ total risk = r βiM (˜M − rF) systematic risk + εi ˜ . Total risk 0.2)2 (0. Example.2. Consider an asset with • annual volatility (σ ) of 40% • market beta of 1.16 c Jiang Wang Fall 2003 15.

11-16 Capital Asset Pricing Model (CAPM) Chapter 11 Example. Two assets with the same total risk can have very different systematic risks.19 15.10 Software 0.2)2 + 0.2) = 47% R1 0.2)2 + 0.5 0.407 Lecture Notes Fall 2003 c Jiang Wang .2) = 5%. However 2 2 2 = (1.19.19 2 2 2 = (0.5) (0.10 = 0.5)2 (0.18 What is the total variance of each return? 2 2 2 2 σ1 = β1M σM + σ1ε = (1.19 2 2 2 2 σ2 = β2M σM + σ2ε = (0.5)2 (0.18 = 0. Stock 1 2 Business Market beta Residual variance Steel 1.5 0. Suppose that σM = 20%. R2 0.5) (0.

• α measures an asset’s return in access of its risk-adjusted award according to CAPM. What to do with an asset of positive α? • Check estimation error.Chapter 11 Capital Asset Pricing Model (CAPM) 11-17 Alpha r ˜ ri − rF = αi + βiM (˜M − rF) + εi ˜ • According to CAPM. • Positive α may be compensating for other risks. c Jiang Wang Fall 2003 15.. • . α should be zero for all assets. • Past value of α may not predict its future value.407 Lecture Notes ..

Regress historic returns of IBM and Dell on the returns on the value-weighted portfolio.63.VW (¯VW − rF ) ¯ r = 0. 1. Required rates of return on IBM and Dell.04 + (0.28%.02%.VW = 1.086) = 0. 5. Suppose it is rF = 4%. Applying CAPM: rIBM = rF + βIBM. Use the value-weighted stock portfolio as a proxy for the market portfolio. 2. 3. Similarly.1028.407 Lecture Notes Fall 2003 c Jiang Wang .73)(0.VW = 0.11-18 Capital Asset Pricing Model (CAPM) Chapter 11 5 Applications of CAPM Example. The expected rate of return on IBM (under CAPM) is 10. Obtain the current riskless rate.73 and βDell. Use historic excess returns on the value weighted portfolio to estimated average market premium: π = rVW − rF = 8. the expected rate of return on Dell is 18.6%. ¯ 4. Suppose the beta estimates are βIBM. 15.

Beta AmerAlia 2. Err.Chapter 11 Reading the Beta Book MLPF&S’s Beta Book 00/03 Close Price Beta 10.93 9. 60 60 17 60 60 c Jiang Wang Ticker Symbol AALA AOL GNLK GM TSN Capital Asset Pricing Model (CAPM) Fall 2003 Note: (a) S&P 500 is used as a proxy for the market.15 -0.– Std of of R-Sqr.12 16.40 GeneLink 0.26 6.30 6.407 Lecture Notes 11-19 .27 0.92 -4.13 Resid –Std.55 1. not risk risk premiums.125 1.25 America Online 67. 15.21 1.72 17.44 0.99 1. (c) Adjusted beta is obtained using other information.25 0.10 0. of Obs.15 2.813 1.06 -1.79 0.01 Tyson Foods 11.290 -7.98 8.74 General Mtrs 82. The alpha.03 0.31 0. (b) Betas are estimated with raw returns. according to CAPM.05 4. Beta Alpha Num.21 0.17 37. Dev-N.23 42.44 1.57 -2.250 -2.01 1.30 0.52 2.09 Alpha Adj.438 2. is rF (1 − β).

407 Lecture Notes Fall 2003 c Jiang Wang . “Beta and return.”) The dots show the actual average risk premiums from portfolios with different betas. Long-run average returns are significantly related to beta: (Source: Fisher Black.11-20 Capital Asset Pricing Model (CAPM) Chapter 11 6 Empirical Evaluation of CAPM 1. • high beta portfolios generated higher average returns • high beta portfolios fall below SML • low beta portfolios land above SML • a line fitted to the 10 portfolios would be flatter than SML. 15.

Chapter 11 Capital Asset Pricing Model (CAPM) 11-21 2.” The dots show the actual average risk premiums from portfolios with different betas over different periods. The relation between beta and actual average return has been much weaker since the mid-1960s. CAPM does not seem to work well over the last 30 years: Source: Fischer Black.407 Lecture Notes . c Jiang Wang Fall 2003 15. “Beta and return.

French.11-22 Capital Asset Pricing Model (CAPM) Chapter 11 3.407 Lecture Notes Fall 2003 c Jiang Wang . “The Cross-Section of Expected Stock Returns”. 15. Fama and K. Factors other than beta seem important in pricing assets: Source: G. Since mid-1960s: • Small stocks have outperformed large stocks • Stocks with low ratios of market-to-book value have outperformed stocks with high ratios.

3. • Multi-factor CAPM.Chapter 11 Capital Asset Pricing Model (CAPM) 11-23 7 Summary of CAPM CAPM is attractive: 1. 2. It is simple and sensible: • is built on modern portfolio theory • distinguishes systematic risk and non-systematic risk • provides a simple pricing model. Empirical evidence is mixed. c Jiang Wang Fall 2003 15. 2. • Consumption CAPM (C-CAPM). Alternative pricing models might do better. It is difficult to test: • difficult to identify the market portfolio • difficult to estimate returns and betas.407 Lecture Notes . CAPM is controversial: 1. • APT. It is relatively easy to implement.

407 Lecture Notes Fall 2003 c Jiang Wang . all efficient frontier portfolios lie on the “Capital Market Line” (CML): Capital Market Line (CML) E[˜] r T CML v ¨¨ rm ¯ ` ` ` ` ` ` ` ` ` ` ` ` ` ` ` ` ¨¨ s ¨ ` ` ¨¨ ` ¨¨ ` ¨ ` ¨ ¨ ` ¨ ` ¨ ` rF ¨ ` ` ` ` ` m ¨¨¨ ¨ ¨¨ ¨ ¨¨ rp ¯ ¨¨      rm − r F ¯ σp σm E σ • Investors hold only portfolios on CML • The risk of an efficient frontier portfolio is its StD • CML gives the trade-off between portfolio risk and return • The price of one unit risk for an efficient portfolio is E[˜m ] − rF r σm [the risk premium on market portfolio per unit of its StD]. 15.11-24 Capital Asset Pricing Model (CAPM) Chapter 11 8 Appendix A: Capital Market Line In the presence of a risk-free asset.

rm −rF . .Chapter 11 Capital Asset Pricing Model (CAPM) 11-25 9 9. Thus. even if investors actually invest for a long horizon. . . c Jiang Wang Fall 2003 15. σm . CAPM may work when future investment opportunities are the same as today. • They may accept lower expected returns on assets that help to hedge against such shifts. Thus • Investors may worry about unfavorable shifts in future investment opportunities.1 Appendix B: Extensions of CAPM Multifactor CAPM In CAPM. n) ¯ • investors’ risk preferences same as today. however: • Investors do invest over long horizons • Investment opportunities do change over time. βim (i = 1.407 Lecture Notes . . In practice. Investors have only short horizons. or 2. Investors’ asset demand does not change over time • future returns same as today: – the same rF . investors care about returns on their investments over the next short horizon — they follow myopic investment strategies. Myopic strategy is optimal if 1.

11-26 Capital Asset Pricing Model (CAPM) Chapter 11 Example. there are two types of systematic risks: 1. Graduating MBAs saving for retirement may worry about a fall in future real interest rates. Static (temporal) — Market risk 2. • They would be willing to accept low returns on these assets (relative to CAPM predictions). Dynamic (intertemporal) — Changes in investment opportunities. construct a portfolio q that is uncorrelated with the market but highly correlated with changes in real interest rates. Multi-factor CAPM tries to model the two types of systematic risk and how these risks are priced: 15. 3. an asset’s premium is given by a multi-factor CAPM: r ri − rF = βim (¯m −rF ) + βiq rq −rF . In order to hedge the interest rate risk. Investors demand to be rewarded for bearing both types of risks. 2. How does this work? 1. • They might not be content with holding the market portfolio and the riskless asset. The optimal portfolio now consists of three funds — “three-fund separation”: • riskless asset • market portfolio • hedging portfolio q . • They might overweight assets that do well if real interest rates fall. ¯ ¯ In general. In equilibrium.407 Lecture Notes Fall 2003 c Jiang Wang .

Chapter 11 Capital Asset Pricing Model (CAPM) 11-27 • Identify macroeconomic variables. • Model has the potential to fit data better. ¯ ¯ ¯ where rf k is the return on the portfolio that is correlated with only the ¯ k-th factor. • Model does may not specify the relative importance of these intertemporal risks. c Jiang Wang Fall 2003 15. Advantages of multi-factor CAPM: • Model captures different types of systematic risk (a) temporal (b) intertemporal. the “factors”. • Hypothesize that the risk premium on an asset is linearly related to the risk premium on these portfolios: ri −rF = αi + βi1 rf 1 −rF + . Weaknesses of multi-factor CAPM: • Model does may not identify the macroeconomic variables that constitute intertemporal risks. + βiK rf K −rF . that might affect investment opportunities. • The factor beta’s can be estimated using regression analysis. . . as in the case of CAPM.407 Lecture Notes . • Find portfolios of traded securities that are highly correlated with these factors.

cut consumption today and invest in asset i. and achieve utility u1 (˜1 )(1 + ri ). The theory itself gives little information on these factors and the data we have may not provide sufficient information either. at the optimum: u0 (c0 ) = E u1 (˜1 )(1 + ri ) .2 Consumption CAPM (CCAPM) To use the multifactor CAPM.11-28 Capital Asset Pricing Model (CAPM) Chapter 11 9. • If 2 is better. However. Consume $1 today • achieve utility u0 (c0 ). c ˜ At optimum.407 Lecture Notes Fall 2003 c Jiang Wang . Invest the $1 in asset i • receive $(1 + ri ) tomorrow ˜ • consume the payoff. we need to identify different sources of intertemporal risks in asset returns and specify their relative importance to investors. sell asset i and consume today. or 2. c 15. for the risk-free asset: u0 (c0 ) = E u1 (˜1 )(1 + rF ) . 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. Thus. c ˜ In particular. Consider a representative investor who decides between how much to invest in each asset: She faces the following choices: 1. • If 1 is better. she should be indifferent between choice 1 and 2.

ri . ˜ ˜ E[˜y ] = Cov[˜.Chapter 11 Capital Asset Pricing Model (CAPM) 11-29 Take the difference between the two equations: E u1 (˜1 ) (˜i − rF ) = 0. (b) For Cov u1 (˜1 ). x˜ x ˜ ¯¯ Thus ri − r F = − ¯ 1 E u1 (˜1 ) c Cov u1 (˜1 ). c Jiang Wang Fall 2003 15. ri < 0 c ˜ • asset i pays when future marginal utility of money is low • its payoff is less valuable • it commands positive premium. c r Observation: For two random variables x and y . y ] + xy . c ˜ (a) For Cov u1 (˜1 ). an asset’s risk is measured by the covariance between its return and investors’ marginal utility. ri > 0 • asset i pays when future marginal utility money is high • its payoff is more valuable • it commands negative premium. Thus.407 Lecture Notes . c ˜ An asset’s risk premium is negatively related to the covariance between its return and an investor’s future marginal utility. Observation: The above must be true for any investor who is at optimum.

15. Advantages of CCAPM: • It gives the most general theory of risk. which is lacking. we have Et [˜it+1 ] − rFt = − r 1 Et u1 (˜t+1 ) c Covt ut+1 (˜t+1 ). rit+1 .11-30 Capital Asset Pricing Model (CAPM) Chapter 11 More generally. • 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. • Theory relies on rationality of individual investors.407 Lecture Notes Fall 2003 c Jiang Wang . c ˜ This is the Consumption CAPM.

407 Lecture Notes . Assignment: • Problem Set 8. Black). c Jiang Wang Fall 2003 15. • Readings package: “Beta and return” (F.2.3. • BM Chapters 8. 8.Chapter 11 Capital Asset Pricing Model (CAPM) 11-31 10 Homework Readings: • BKM Chapters 9. • Project 2 on equity portfolio management.

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