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

Suppose there are a total of i = 1.11-4 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. n MCAPj MCAPM j=1 We denote the market portfolio by wM. Definition: The market capitalization of an asset is its total market value. n risky assets. . The total market capitalization of all risky assets is n MCAPM = i=1 MCAPi. Asset i’s market capitalization is MCAPi = (price per share)i × (# of shares outstanding)i.407 Lecture Notes Fall 2003 c Jiang Wang . . 15. . The market portfolio is the portfolio with weights in each risky asset i being wi = MCAPi MCAPi = . .

2. 3. 3.407 Lecture Notes . Implications: 1.Chapter 11 Capital Asset Pricing Model (CAPM) 11-5 3 Derivation of CAPM Assumptions for this chapter: 1. 4. All investors hold the risky assets in same proportions • they hold the same risky portfolio. c Jiang Wang Fall 2003 15. Demand of assets equals supply in equilibrium. There is a risk-free asset: • paying interest rate rF • in zero net supply. The tangent portfolio is the market portfolio. Investors have the same fixed (static) investment horizon. 5. Every investor puts their money into two pots: • the riskless asset • a single portfolio of risky assets – the tangent portfolio. 2. Investors agree on the distribution of asset returns. Investors hold efficient frontier portfolios. the tangent portfolio.

There are only three risky assets.1 A Numerical Illustration of CAPM CAPM requires that in equilibrium total asset holdings of all investors must equal the total supply of assets.50. wB . There are only three investors in the economy. respectively.407 Lecture Notes Fall 2003 c Jiang Wang .25). 1000. Suppose that the tangent portfolio is wT = (wA . We show this through the example below. 1. 0.25. 2 and 3. A. 15. 1500 billion dollars.11-6 Capital Asset Pricing Model (CAPM) Chapter 11 3. B and C. 0. with total wealth of 500. 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 . wC ) = (0.

50 1. 0. The market portfolio is the tangent portfolio: wM = 750 1500 750 .0 Standard Deviation (%. 4.0 8.0 6. .00 0.00 0.0 4. 3000 3000 3000 5.50.50 Return (%.0 10.0 3. 0.00 3.Chapter 11 Capital Asset Pricing Model (CAPM) 11-7 In equilibrium. per month) c Jiang Wang Fall 2003 15. per month) 3.00 T=M 2.0 5. 000 billion.25) = wT .50 Efficiency frontier 4.00 = (0.0 1.00 1.25.0 7.0 9. The total market capitalization is 750 + 1500 + 750 = $3.50 2.50 0.0 2.407 Lecture Notes . 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.

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

2. • Bearing nonsystematic risk need not be rewarded. • Bearing systematic risk needs to be rewarded. can be diversified away by holding a frontier portfolio. Combining the risk-free asset and the market portfolio gives the portfolio frontier. 5. The part of an asset’s risk that is not correlated with the market portfolio.3 Implications of CAPM 1. The part of the risk that is correlated with the market portfolio. c Jiang Wang Fall 2003 15. cannot be diversified away.Chapter 11 Capital Asset Pricing Model (CAPM) 11-9 3.407 Lecture Notes . 3. The risk of an individual asset is characterized by its covariability with the market portfolio. 4. the systematic risk. the non-systematic risk. The market portfolio is the tangent portfolio.

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

4%. What should be the expected return on a stock with β = 0? Answer: Same as the risk-free rate. What should be the expected return on a stock with β = 1? Answer: The same as the market return. • This uncertainty is uncorrelated with the market return. ¯ 4. 1.Chapter 11 Capital Asset Pricing Model (CAPM) 11-11 Example. 14%.407 Lecture Notes . 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. The expected market return is 14% and T-bill rate is 5%.14 − 0.6)(0.05) = −0. 5%.5)(0.5%.05 + (−0. 2.6? Answer: The expected return should be r = 0. Note: • The stock may have significant uncertainty in its return. ¯ How can this be? c Jiang Wang Fall 2003 15. What should be expected return on stock with β = −0.14) = 9.05) + (0. Suppose that CAPM holds.5)(0.

11-12 Capital Asset Pricing Model (CAPM) Chapter 11 4 Understanding Risk in CAPM In CAPM. r ˜ Three characteristics of an asset: • Beta. • Sigma = StD (εi).407 Lecture Notes Fall 2003 c Jiang Wang . 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. 15. εi] = 0. ˜ • Alpha.

2 (Market premium = 8%. market volatility = 25%. asset volatility = 40%.5 0.5 0 −0.) Solid lines – asset rturns.2 2 1.5 10 20 time 30 40 return 1 1 0.5 asset return 1 0.6 0.6 0.5 asset beta = 1.4 0.2 return 0.5 0. Two assets with same total volatility but different betas asset beta = 0.5 2 1.5 0 −0. • Assets with higher betas are more sensitive to the market. c Jiang Wang Fall 2003 15.5 2 1.4 0. Dotted lines – market returns.8 1 market return 1.5 10 20 time 30 40 2 1.2 asset return 1 0.5 0 −0.407 Lecture Notes .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.8 1 market return 1.5 0 −0.

407 Lecture Notes Fall 2003 c Jiang Wang .5 0 −0.5 0 −0. 15.5 10 20 time 30 40 1. Dotted lines – market returns.) Solid lines – asset rturns.5 10 20 time 30 40 return 0. market volatility = 25%.2 return 0.5 10 20 time 30 40 return 0.5 0 −0.11-14 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. asset volatility = 40%.5 1 1.5 1 1. Dashed lines – idiosyncratic component.2 1. Two assets with same total volatility but different betas asset beta = 0.5 0 −0.5 1 asset beta = 1.5 1 return 0. • Non-systematic risk is uncorrelated with systematic risk. Dashdot lines – market component.5 10 20 time 30 40 (Market premium = 8%.

Consider an asset with • annual volatility (σ ) of 40% • market beta of 1. 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? (0.25)2 + Var[˜]. ε σε = 0.16 c Jiang Wang Fall 2003 15.2645. ε Var[˜] = 0. Non-systematic risk 0. Total risk 0. Systematic risk is only a part of return volatility.407 Lecture Notes .2.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 ˜ .0700.2)2 (0. Example.75%.4)2 = (1.07 = = 43. non-systematic risk Var[˜i] r = 2 βiMVar[˜M] r + Var[˜i] ε .

5)2 (0.2)2 + 0.10 = 0.18 What is the total variance of each return? 2 2 2 2 σ1 = β1M σM + σ1ε = (1.5 0.19 2 2 2 = (0. R2 0.2)2 + 0.19 15.5 0.407 Lecture Notes Fall 2003 c Jiang Wang .19.10 Software 0. Two assets with the same total risk can have very different systematic risks.5) (0.2) = 5%.19 2 2 2 2 σ2 = β2M σM + σ2ε = (0.2) = 47% R1 0.18 = 0.5) (0. However 2 2 2 = (1.5)2 (0. Stock 1 2 Business Market beta Residual variance Steel 1. Suppose that σM = 20%.11-16 Capital Asset Pricing Model (CAPM) Chapter 11 Example.

c Jiang Wang Fall 2003 15.407 Lecture Notes .. • . • Past value of α may not predict its future value.Chapter 11 Capital Asset Pricing Model (CAPM) 11-17 Alpha r ˜ ri − rF = αi + βiM (˜M − rF) + εi ˜ • According to CAPM. What to do with an asset of positive α? • Check estimation error. • α measures an asset’s return in access of its risk-adjusted award according to CAPM. α should be zero for all assets. • Positive α may be compensating for other risks..

VW = 0. Obtain the current riskless rate. Required rates of return on IBM and Dell.11-18 Capital Asset Pricing Model (CAPM) Chapter 11 5 Applications of CAPM Example. Use the value-weighted stock portfolio as a proxy for the market portfolio.73 and βDell.73)(0. the expected rate of return on Dell is 18.63. Similarly.VW (¯VW − rF ) ¯ r = 0. The expected rate of return on IBM (under CAPM) is 10. 5. Use historic excess returns on the value weighted portfolio to estimated average market premium: π = rVW − rF = 8.28%.02%. Suppose the beta estimates are βIBM. Regress historic returns of IBM and Dell on the returns on the value-weighted portfolio. 15. 3.407 Lecture Notes Fall 2003 c Jiang Wang . 1. Suppose it is rF = 4%. ¯ 4.VW = 1.6%. 2.1028. Applying CAPM: rIBM = rF + βIBM.086) = 0.04 + (0.

93 9.– Std of of R-Sqr. Err.15 2.03 0. of Obs.407 Lecture Notes 11-19 .21 1.12 16.26 6.74 General Mtrs 82.05 4.250 -2.44 0.52 2.25 0.72 17. The alpha. 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. Dev-N.17 37.55 1.09 Alpha Adj. Beta Alpha Num.23 42. (c) Adjusted beta is obtained using other information. Beta AmerAlia 2.27 0.125 1.98 8. is rF (1 − β). according to CAPM.10 0.290 -7.01 Tyson Foods 11.30 6.99 1.13 Resid –Std.79 0.06 -1.21 0.Chapter 11 Reading the Beta Book MLPF&S’s Beta Book 00/03 Close Price Beta 10.813 1. (b) Betas are estimated with raw returns.438 2.44 1. 15.31 0.25 America Online 67. not risk risk premiums.92 -4.15 -0.30 0.01 1.40 GeneLink 0.57 -2.

• 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. “Beta and return. 15. Long-run average returns are significantly related to beta: (Source: Fisher Black.”) The dots show the actual average risk premiums from portfolios with different betas.11-20 Capital Asset Pricing Model (CAPM) Chapter 11 6 Empirical Evaluation of CAPM 1.407 Lecture Notes Fall 2003 c Jiang Wang .

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

Since mid-1960s: • Small stocks have outperformed large stocks • Stocks with low ratios of market-to-book value have outperformed stocks with high ratios. 15. Factors other than beta seem important in pricing assets: Source: G.11-22 Capital Asset Pricing Model (CAPM) Chapter 11 3. Fama and K.407 Lecture Notes Fall 2003 c Jiang Wang . “The Cross-Section of Expected Stock Returns”. French.

It is simple and sensible: • is built on modern portfolio theory • distinguishes systematic risk and non-systematic risk • provides a simple pricing model. CAPM is controversial: 1. • Consumption CAPM (C-CAPM). 2. 3. • Multi-factor CAPM. Empirical evidence is mixed. It is difficult to test: • difficult to identify the market portfolio • difficult to estimate returns and betas. c Jiang Wang Fall 2003 15.407 Lecture Notes . 2. Alternative pricing models might do better.Chapter 11 Capital Asset Pricing Model (CAPM) 11-23 7 Summary of CAPM CAPM is attractive: 1. It is relatively easy to implement. • APT.

407 Lecture Notes Fall 2003 c Jiang Wang . 15.11-24 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[˜] 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].

σm . βim (i = 1.Chapter 11 Capital Asset Pricing Model (CAPM) 11-25 9 9. Thus • Investors may worry about unfavorable shifts in future investment opportunities.1 Appendix B: Extensions of CAPM Multifactor CAPM In CAPM. . • They may accept lower expected returns on assets that help to hedge against such shifts. Investors’ asset demand does not change over time • future returns same as today: – the same rF . even if investors actually invest for a long horizon. . Investors have only short horizons. c Jiang Wang Fall 2003 15. . . CAPM may work when future investment opportunities are the same as today. n) ¯ • investors’ risk preferences same as today. Thus. Myopic strategy is optimal if 1. In practice. or 2.407 Lecture Notes . however: • Investors do invest over long horizons • Investment opportunities do change over time. rm −rF . investors care about returns on their investments over the next short horizon — they follow myopic investment strategies.

• They might overweight assets that do well if real interest rates fall. Multi-factor CAPM tries to model the two types of systematic risk and how these risks are priced: 15. 3.407 Lecture Notes Fall 2003 c Jiang Wang . In equilibrium. there are two types of systematic risks: 1. ¯ ¯ In general. • They would be willing to accept low returns on these assets (relative to CAPM predictions).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. construct a portfolio q that is uncorrelated with the market but highly correlated with changes in real interest rates. Dynamic (intertemporal) — Changes in investment opportunities. In order to hedge the interest rate risk. Investors demand to be rewarded for bearing both types of risks. an asset’s premium is given by a multi-factor CAPM: r ri − rF = βim (¯m −rF ) + βiq rq −rF . The optimal portfolio now consists of three funds — “three-fund separation”: • riskless asset • market portfolio • hedging portfolio q . Static (temporal) — Market risk 2. 2. How does this work? 1.

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

11-28 Capital Asset Pricing Model (CAPM) Chapter 11 9. cut consumption today and invest in asset i. • If 2 is better. Invest the $1 in asset i • receive $(1 + ri ) tomorrow ˜ • consume the payoff. The theory itself gives little information on these factors and the data we have may not provide sufficient information either. • If 1 is better. c 15.2 Consumption CAPM (CCAPM) To use the multifactor CAPM. c ˜ In particular. Consume $1 today • achieve utility u0 (c0 ). we need to identify different sources of intertemporal risks in asset returns and specify their relative importance to investors. 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. at the optimum: u0 (c0 ) = E u1 (˜1 )(1 + ri ) . c ˜ At optimum. she should be indifferent between choice 1 and 2. Thus. and achieve utility u1 (˜1 )(1 + ri ).407 Lecture Notes Fall 2003 c Jiang Wang . sell asset i and consume today. Consider a representative investor who decides between how much to invest in each asset: She faces the following choices: 1. or 2. for the risk-free asset: u0 (c0 ) = E u1 (˜1 )(1 + rF ) .

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

Advantages of CCAPM: • It gives the most general theory of risk. • Implementation relies on consumption data. • Theory relies on rationality of individual investors. 15. • There is really only one risk — the risk in future consumption. Weaknesses of CCAPM: • Theory itself does not specify investors’ marginal utilities.11-30 Capital Asset Pricing Model (CAPM) Chapter 11 More generally.407 Lecture Notes Fall 2003 c Jiang Wang . rit+1 . c ˜ This is the Consumption CAPM. which is lacking. we have Et [˜it+1 ] − rFt = − r 1 Et u1 (˜t+1 ) c Covt ut+1 (˜t+1 ).

• Project 2 on equity portfolio management. Black).Chapter 11 Capital Asset Pricing Model (CAPM) 11-31 10 Homework Readings: • BKM Chapters 9. c Jiang Wang Fall 2003 15. • Readings package: “Beta and return” (F.2.407 Lecture Notes .3. 8. Assignment: • Problem Set 8. • BM Chapters 8.

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