CAPM Teaching Notes 1. In going from Markowitz efficient frontier to CAPM, we add one new concept. What is it?

There exists a risk-free asset. 2. Assumptions of CAPM: All investors are Markowitz efficient frontier investors Can borrow or lend at RFR Homogeneous expectations, thus everyone agrees on location of efficient frontier One-period model No taxes or transaction costs Capital markets are in equilibrium Unrealistic expectations: But you judge a theory by how useful it is in explaining reality! 3. CAPM A straight line would connect Rf asset to any point on efficient frontier Why not Portfolio M-the tangent portfolio For now, think of Portfolio M as a bond-stock portfolio (balanced fund) Suppose you could lend but not borrow at RFR. How could you attain portfolio between RF and M? How could you attain portfolio M? Suppose you could lend and borrow at RFR. How could you attain portfolio above and to right of portfolio M? [Discuss the idea of borrowing at rate above RFR. Similar curve to CML except there is a kink in the curve] New Efficient frontier is the CML Q: What assets are in theoretical portfolio M? 1)All risky assetsstocks, bonds, real estate, commodities (e.g., medals) and 2) in proportion to their market values. Discuss above. This idea gave rise to index funds Separation Theory: Investment Decision: All investors want Portfolio M; all rational investors will fully diversify. Financing Decision: some investors will lend to government at RFR (i.e., by Treasury securities), while others borrow at RFR using leverage (financing decision).

4. Q: Since everyone invests in portfolio M, how should we measure the risk of an asset within portfolio M? How does the risk of the asset affect the risk of this diversified portfolio? Depends upon the assets covariance of returns with the market portfolio. Beta is a measure of the covariance of an assets returns with the market, where covariance is closely related to correlation coefficient. Market risk (Macro factors) Comp. specific risk (micro factors) Total Risk = Systematic Risk + Unsystematic risk Variance Market Risk Nonmarket risk Standard dev. Nondiversifiable Risk Diversifiable risk Beta is a measure of systematic risk. Standardized measure of systematic or market risk. Q: What does a beta of 1 mean? 1.2 mean? Since everyone holds diversified portfolios, ER = f(systematic risk). You only get rewarded in terms of higher expected return for bearing risk that cannot be easily diversified. Nondiversified investors are bearing unsystematic riskrisk that they are not getting rewarded for in terms of higher expected returns. Q: In CAPM, why would we not get rewarded in terms of higher expected returns for bearing diversifiable risk? In equilibrium, required rates of returns are equal to expected rates of return: ERi = RFR + Bi (Rm RFR) For bearing beta = 0 risk, you get ER = RFR. ER rises with beta risk, that is, nondiversifiable risk. In equilibrium, all securities plot on SML.

5. Momma, where do betas come from? Suppose we are trying to calculate the beta for the Hartford Stock Fund (A shares). How does Morningstar do it? 36 monthly returns. One-month T-bills as Rf asset, and S&P 500 as M-market proxy. Recall that portfolio M contains stocks and bonds and other risky assets. Yet, in practice, we tend to use a stock index to measure a stock funds beta risk relative to a stock index (and a bond index to measure a bond funds risk relative to a bond index) --Plot of monthly excess returns: alpha (y-intercept) and beta (slope of characteristic line) A mutual funds alpha is its measure of risk-adjusted performancethe managers report card and the measure of value added. Beta is a measure of the level of systematic risk. Text Equation 8.7 (p. 244): Rit = ai + biRMt + et (Rit-RFR) = ai + bi (RMt RFR) + et Text Equation 8.6 (p. 240): ERi = RFR + Bi(Rm RFR) CAPM R2 measure of diversification: the percent of variance of returns that can be explained by the market portfolio. In practice, betas of individual stocks are highly unstable discuss (squirrelly), but betas of portfolios are more stable. Change the market proxythat is, the measure of the marketand you change the alpha and beta. Go to Morningstar Reports. Selecting the market proxy is an important decision when measuring a funds (or assets) risk and risk-adjusted returns. 6. Next lecture we will look at performance measurements using CAPM and portfolio theory through the CAPM. Sharpe ratio, Treynor ratio, (Jensens) alpha, information ratio. Later, we will look at additional approaches adopted since the early 1990s to measuring performance.