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Lecture 6

Capital Asset Pricing Model


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 how to partition the risk of an asset into a
systematic and an unsystematic part, and why it is
important
– Understand generally that CAPM has some strong
assumptions which may not hold in the reality
(and thus CAPM may not hold exactly)

2
Implications of the separation theorem
• All investors will end up holding the same optimal risky
portfolio P* - this portfolio by construction is the market
portfolio.
• The market portfolio is the value-weighted portfolio of all
assets – i.e. weight of each asset in the market portfolio is
the assets total market value divided by the total value of
the portfolio.
• Since every investor is holding the market portfolio for their
risky asset allocation, the risk of an asset is measured by
how much risk it adds when it is combined with the market
portfolio.
• This observation provides the intuition behind the CAPM.

3
Risk Contribution

Contribution of GE’s stock to the variance of the


portfolio:
𝑤𝐺𝐸 [𝑤1 𝐶𝑜𝑣 𝑟1 , 𝑟𝐺𝐸 +𝑤2 𝐶𝑜𝑣 𝑟2 , 𝑟𝐺𝐸 + …… +𝑤1 𝐶𝑜𝑣 𝑟𝑛 , 𝑟𝐺𝐸 ]

4
Expected return and risk contribution
• The return of the portfolio of all risky assets, denoted
as portfolio M, is:
– rM = ∑j wjrj, and wj = Valuej /∑j Valuej
– E[rM] = ∑j wj E[rj]
– Var[rM] = Cov[rM, rM] = Cov[∑j wjrj, rM] = ∑j wj Cov[rj, rM]

• So asset j’s contribution to the market portfolio’s


expected return is wj E[rj]
• So asset j’s contribution to the market portfolio’s
variance is wj Cov[rj, rM]
• Should these two be related?
CAPM derivation 5
Expected excess return and risk contribution
• It is reasonable to speculate that E[rj] should be
related to Cov[rj, rM] in a positive way
– i.e., the more an asset contributes to the market portfolio’s
risk, the higher its expected return
– The risk-free asset does not contribute any to the market
portfolio’s risk, but still carries a return of rf.
– So maybe we should link (E[rj] – rf ) with (Cov[rj, rM] -
Cov[rf, rM]) – which is Cov[rj, rM] anyway

6
CAPM derivation
Capital Asset Pricing Model - CAPM
• Let’s assume it very informally:
– E[rj] – rf = c*Cov[rj, rM] [1]

• Let’s take asset j as the market portfolio M itself


– then E[rM] – rf = c*Cov[rM, rM]
– So c = (E[rM] – rf)/Var(rM) [2]

• Let’s put the expression of c in eq. [2] back to eq. [1]


and we get the CAPM!
– E[rj] – rf = (E[rM] – rf)/Var(rM) *Cov[rj, rM]
– Define βj = Cov[rj, rM] /Var(rM)
– E[rj] – rf = βj*(E[rM] – rf)

CAPM derivation 7
Capital Asset Pricing Model - CAPM
• So we derive the CAPM in a very informal way:
– E[rj] – rf = βj*(E[rM] – rf)
– Where βj = Cov[rj, rM] /Var(rM)

• So an asset j’s expected return in excess of the risk-free rate


(also termed as its risk premium) equals its risk times the
price of the risk
– Its risk is measured by its relative contribution to variance of market
portfolio, βj = Cov[rj, rM] /Var(rM) – which in turn depends on how it co-
varies with market portfolio
– Price of risk is excess return of market portfolio (in excess of risk-free
rate, sometimes referred as market risk premium)
– And in equilibrium, no asset is too ‘good’ or too ‘bad’. More risky (or
less ‘attractive’) assets are compensated with higher expected returns
to make them equally favorable investments as those less risky ones

CAPM derivation 8
Two special assets
• For the market portfolio M itself, the CAPM simplifies to:
Cov rM , rM 
M  1
 M2
E rM   rf   M E rM   rf   rf  1 * E rM   rf   E rM 

• For the risk free asset the CAPM simplifies to:


Cov rf , rM 
f  0
 2
M

E rf   rf   f E rM   rf   rf  0 * E rM   rf   rf

– For M and f the CAPM is simply an identity


– Their expected returns are set by the specific preference of all investors that
trade in the market
– These are very hard to figure out and we’ll 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
Security Market Line 9
The Security Market Line
• We can illustrate this in a graph similar to the Capital Allocation Line (CAL)
• Each asset j is compensated with excess return in relation to its risk in the
market portfolio
• We denote the risk ratio in the CAPM with i  Covri , rM   M2
• According to the CAPM, all assets plot on a straight line between f and M
in E(r) - β space (not E(r) - σ space)
• We call this line the Security Market Line, SML

Slope  E ( rM )  rf
E ri 
SML
M

rf

f  0 M  1 i
Security Market Line 10
β
• An asset’s β measures how much risk the assets
contributes in the market portfolio, relative to the
contribution of the average asset (i.e., the market
portfolio – which is the weighted average of all risky
assets)

• βi > 1 means that Cov(ri, rM) > Var(rM), or that the


asset contributes more risk than the average asset
• βi < 1 means that Cov(ri, rM) < Var(rM), or that the
asset contributes less risk than the average asset

Security Market Line 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 β = 0.5 contributes half the risk of the average asset and
gets half the reward in terms of excess returns
– An asset with β = 2 contributes twice the risk of the average asset and
gets twice the reward in terms of excess returns

Slope  E ( rM )  rf
E ri 
SML
M

rf
Covri , rM 
f  0 M  1 i 
 M2
Security Market Line 12
A regression formulation
• CAPM only tells us the relation between an asset’s
expected excess return with its beta and market
expected excess return
• i.e., E[rj] – rf = βj*(E[rM] – rf)

• The realized returns of the asset and the market portfolio


may deviate from their expected ones, which makes the
above equation not hold for realized returns

• But if CAPM is correct, the deviation of realized returns


from the CAPM relation should be random, i.e.,
sometimes positive and sometimes negative without a
specific pattern
• rj = rf + βj*(rM – rf) + ε, where E(ε) = 0 and corr(ε, rM) = 0
Systematic versus idiosyncratic risks 13
A regression formulation
• Recall from statistics, the univariate OLS regression model:
Y    X  
• The value of β is Cov  X , Y 

Var  X 
• In our case, X = rM – rf and Y = rj and α = rf:
Cov rj , rM  rf  Cov rj , rM 
j  
Var rM  rf  Var rM 

rj  rf   j rM  rf   

• So beta could be estimated from regressing asset j’s returns


on market excess returns

Systematic versus idiosyncratic risks 14


Decomposing total risk (variance) of an asset
• Given this formulation, ri  rf  i rM  rf    , we can calculate
the return variance (total risk) of an asset:
Var ri   Var rf   i rM  rf    
Var ri   Var  i rM  rf    
Var ri    i2Var rM  rf   Var    2  iCov rM  rf ,  
Var ri    i2Var rM   Var    2 Cov rM ,  
Var ri    i2Var rM   Var  

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


applying our usual manipulations of variances
– The fourth step follows again as rf is a constant
– The final step follows since ε is uncorrelated to rM

Systematic versus idiosyncratic risks 15


Decomposing total risk (variance) of an asset
• We see that variance of an asset can be partitioned into two parts

Var ri    i2Var rM   Var  


 i2   i2 M2   2

• The first term in the expression is called systematic risk or market


risk
– Recall that β is a measure of the risk the asset contributes in the
market portfolio, relative to the contribution of the average asset.
– β depends on how the asset co-varies with market portfolio
– The systematic risk is the part of an asset’s risk that is in common with
the market, and thus unable to be diversified
• The second term in the expression is called unsystematic risk or
idiosyncratic risk
– The unsystematic risk is the part of an asset’s 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
Systematic versus idiosyncratic risks 16
Example of systematic risk sources
• 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

Systematic versus idiosyncratic risks 17


Example of idiosyncratic risk sources
• 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 it is unlikely that everyone steps on a nail on the
same day, and so 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

Systematic versus idiosyncratic risks 18


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 and thus you should do it)
– Unsystematic risk hurts as much as systematic risk
unless it’s diversified away
– The implication is that we should always hold well-
diversified portfolios
Systematic versus idiosyncratic risks 19
The SML and the CAL
• CAL relates expected returns to total risk measure (volatility)
for efficient portfolios
– The total risk is compensated only for those efficient portfolios on the
CAL - the portfolio of risk-free asset and the market portfolio
– For these portfolios, all idiosyncratic risks are diversified away, and
thus total risk equals to the systematic risk
– Individual assets will typically plot under the CAL
– An asset’s risk to the left of the CAL is systematic (and earns expected
returns), but its risk to the right of the CAL is unsystematic (and earns
no extra expected return)
E ri 
CAL
P*
Systematic risk
A

rf Unsystematic risk


A
Systematic versus idiosyncratic risks 20
The SML and the CAL
• SML relates expected returns to systematic risk
measure (beta) for all assets
– All assets will plot on the SML, because systematic risk (as
measured by beta) is priced (with expected return)

Slope  E ( rM )  rf
E ri 
SML
M

rf
Covri , rM 
f  0 M  1 i 
 M2

Systematic versus idiosyncratic risks 21


Portfolio β
• The β of a portfolio P is defined in the same way as an
individual asset
 P  Cov rP , rM   M2
• The portfolio return: rP  w1r1  w2 r2
• The portfolio beta is the weighted average of the β of the
assets in that portfolio
𝐶𝑜𝑣 𝑟𝑃 , 𝑟𝑀 𝐶𝑜𝑣 𝑤1 𝑟1 + 𝑤2 𝑟2 , 𝑟𝑀
𝛽𝑃 = 2 = 2
𝜎𝑀 𝜎𝑀
𝑤1 𝐶𝑜𝑣 𝑟1 , 𝑟𝑀 𝑤2 𝐶𝑜𝑣 𝑟2 , 𝑟𝑀
= 2 + 2
𝜎𝑀 𝜎𝑀
= 𝑤1 𝛽1 + 𝑤2 𝛽2

• Since the market portfolio consists of all assets on the market


and has β = 1, the (value weighted) average beta of all assets
on the market is one.
Portfolio beta 22
Using the CAPM
• The CAPM has implications for our portfolio choice
– Avoid unsystematic risk by holding a well-diversified portfolio
– Monitor the amount of systematic risk of investments
• The CAPM allows us to evaluate investment performance
– Relate returns to the return benchmark with similar level of systematic
risk taken
– Examine whether the unexpected component of realized return is due
to the idiosyncratic risk of your investment (where good or bad returns
could be totally due to luck)
• We can use the CAPM for capital budgeting purpose
– Estimate the beta for non-traded assets or firm projects from similar
traded assets or firms, and then calculate required returns
– Then estimate the present value of these assets/projects based on
estimated future cash flows and required returns
– Finally decide whether it is worth the cost and produces positive NPV

Miscs 23
• Important: all slides beyond this point are for
your knowledge only and won’t be required
for any assessment purpose.
– This should be clear enough. Please don’t email
me or ask me further whether coverage of these
slides will be examinable or not!

24
Assumptions of CAPM
• Assumption 1: Investors are rational mean-variance optimizers - All investors
maximize a utility function and do so correctly
• Assumption 2: Investors are price takers - No investor is large enough relative
to the market to influence equilibrium prices by her trades
• Assumption 3: Investors have identical investment horizons and agree on the
statistical properties of all assets (expected returns and covariances)
• The above three assumptions will make sure that every investor will do what I
did in lecture 4 to maximize her utility based on the expected return and
volatility of all possible portfolios
• Assumption 4: There is a risk free asset available to all, i.e., all investors can
borrow and invest in this at the same rate
• Assumption 5: All investors can trade all assets (which is not the case in the
reality, for example, human capital is typically viewed as untradeable)
• The above two conditions, combined with the first three assumptions, will
make sure that every investor will find P* (the tangent portfolio) as the
optimal risky portfolio and their final portfolio will be a combination of risk-
free asset and P*
– And since everyone is holding P*, it is the market portfolio of ALL risky assets
• Assumption 6: Perfect capital markets - there are no financial frictions such as
short selling constraints, transaction costs, taxes etc.

Formal derivation of CAPM 25


Formal derivation of CAPM: method 1

• Imagine that we start of with all our money invested


in the market portfolio
– We know from lecture 5 that this portfolio equals P* and
therefore has the highest possible Sharpe ratio
– So any deviation from that portfolio, for example, changing
the weight on an asset j, wj, won’t increase the Sharpe
ratio

Formal derivation of CAPM 26


Formal derivation of CAPM: method 1
• Mathematically, it means the first order derivative of
the market portfolio’s Sharpe ratio, SM, relative to the
weight on an asset j, wj, equals to zero (and the
second order derivative is negative).
– 𝜕𝑆𝑀 Τ𝜕wj = 0, and
𝐸 𝑟𝑀 −𝑟𝑓 σ𝑗 𝑤𝑗 [𝐸 𝑟𝑗 −𝑟𝑓 ]
– 𝑆𝑀 = =
𝜎𝑀 [σ𝑗 𝑤𝑗2 𝜎𝑗2 + σ𝑗 σ𝑖 2𝑤𝑗 𝑤𝑖 𝐶𝑜𝑣(𝑟𝑗 ,𝑟𝑖 ) ]1/2

– If you take derivative of the above expression with respect


to wj and set it to zero, after various manipulations, you
𝐶𝑜𝑣(𝑟𝑗 ,𝑟𝑀 )
will find that 𝐸 𝑟𝑗 − 𝑟𝑓 = (𝐸 𝑟𝑀 − 𝑟𝑓 )
𝜎𝑀 2
– You can verify the negative second order derivative holds.

Formal derivation of CAPM 27


Formal derivation of CAPM: method 2
• Imagine that we start of with all our money invested in the
market portfolio, 𝑟𝑐 = 𝑟𝑀
– We know that this portfolio equals P* and therefore has the highest
possible Sharpe ratio

• Now imagine that we made the following two adjustments to


this portfolio:
– Borrow/lend some very small amount of money, corresponding to a
portfolio weight of λi, and buy/sell an arbitrary asset i
– Borrow/lend some very small amount of money, corresponding to a
portfolio weight of λj, and buy/sell another arbitrary asset j

Formal derivation of CAPM 28


Formal derivation of CAPM: method 2
• Our resulting stochastic return will be
– 𝑟𝑐 = 𝑟𝑀 +λ𝑖 (𝑟𝑖 -𝑟𝑓 ) + λ𝑗 (𝑟𝑗 -𝑟𝑓 )
• And our portfolio expected return and variance will be
– E(𝑟𝑐 ) = E(𝑟𝑀 ) +λ𝑖 (E(𝑟𝑖 )-𝑟𝑓 ) + λ𝑗 (E(𝑟𝑗 )-𝑟𝑓 )
– 𝜎𝑐 2 = 𝜎𝑀2 + λ𝑖 2 𝜎𝑖 2 + λ𝑗 2 𝜎𝑗 2 + 2λ𝑖 𝐶𝑜𝑣 𝑟𝑖 , 𝑟𝑀 +
2λ𝑗 𝐶𝑜𝑣 𝑟𝑗 , 𝑟𝑀 + 2λ𝑖 λ𝑗 𝐶𝑜𝑣 𝑟𝑖 , 𝑟𝑗
• Since we chose very small changes in weights, λ𝑖 and λ𝑗 ,
we may ignore the quadratic term, so that we have
– E(𝑟𝑐 ) = E(𝑟𝑀 ) +λ𝑖 (E(𝑟𝑖 )-𝑟𝑓 ) + λ𝑗 (E(𝑟𝑗 )-𝑟𝑓 )
– 𝜎𝑐 2 = 𝜎𝑀2 + 2λ𝑖 𝐶𝑜𝑣 𝑟𝑖 , 𝑟𝑀 + 2λ𝑗 𝐶𝑜𝑣 𝑟𝑗 , 𝑟𝑀
• Since we started off with the market portfolio, the
change in our portfolio expected return and variance is
– ΔE(𝑟𝑐 ) = λ𝑖 (E(𝑟𝑖 )-𝑟𝑓 ) + λ𝑗 (E(𝑟𝑗 )-𝑟𝑓 )
– Δ 𝜎𝑐 2 = 2λ𝑖 𝐶𝑜𝑣 𝑟𝑖 , 𝑟𝑀 + 2λ𝑗 𝐶𝑜𝑣 𝑟𝑗 , 𝑟𝑀
Formal derivation of CAPM 29
Formal derivation of CAPM: method 2
• Now let’s change the weight in assets i and j in such a way
that our portfolio risk is not affected
 c2  2i Cov  rM , ri   2 j Cov  rM , rj   0
Cov  rM , rj 
i   j
Cov  rM , ri 

• Our resulting expected return change is


E  rc   i  E  ri   rf    j  E  rj   rf 

Cov  rM , rj 
E  rc    j  E  ri   rf    j  E  rj   rf 
Cov  rM , ri   

Formal derivation of CAPM 30


Formal derivation of CAPM: method 2

• Since we started off with the portfolio that had the highest
possible Sharpe ratio, and did not change its risk, we cannot
increase its expected return
• We also cannot decrease the expected return, as that means
we could increase it by “switching” asset i with j, e.g. buy i
and sell j instead of the other way around

Formal derivation of CAPM 31


Formal derivation of CAPM: method 2
• It must therefore hold that

Cov  rM , rj 
E  rc    j  E  ri   rf    j  E  rj   rf   0
Cov  rM , ri   

 Cov  rM , rj  
 j   E  rj   rf  
   E  ri   rf    0
 Cov  rM , ri   
 
Cov  rM , rj 
 E  rj   rf  
 Cov  r , r   E  ri   rf   0
 

M i

E  rj   rf E  ri   rf

Cov  rM , rj  Cov  rM , ri 

Formal derivation of CAPM 32


Formal derivation of CAPM: method 2

• The ratio of the contributions to the combined portfolio’s


excess return and risk (some form of reward to risk ratio)
has to be the same for both assets
E  rj   rf E  ri   rf

Cov  rM , rj  Cov  rM , ri 

• We can interpret these ratios as the price of risk, i.e. how


much excess return do we get per unit of portfolio variance
we take on

Formal derivation of CAPM 33


Formal derivation of CAPM: method 2
• The equation above states that the price of risk has to be the
same for all assets
• Since j was an arbitrary asset, we may substitute any asset for
j, including the market portfolio itself
E  ri   rf E  rM   rf E  rM   rf
 
Cov  rM , ri  Cov  rM , rM   M2

• Solving this equation for the expected (or required) return of


asset i gives us the CAPM
Cov  rM , ri 
E  ri   rf   E  rM   rf 
 M2

Formal derivation of CAPM 34

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