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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
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]
6
CAPM derivation
Capital Asset Pricing Model - CAPM
• Let’s assume it very informally:
– E[rj] – rf = c*Cov[rj, rM] [1]
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)
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
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)
Slope E ( rM ) rf
E ri
SML
M
rf
Covri , 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)
rj rf j rM rf
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
Covri , rM
f 0 M 1 i
M2
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.
Cov rM , rj
E rc j E ri rf j E rj rf
Cov rM , ri
• 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
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