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MEMORANDUM

TO: Dr. Cristobal de la Torre


FROM: Stephanie Slaughter
DATE: May 31, 2013
SUBJECT: CAPM Project

The Capital Asset Pricing Model specifies the relationship between risk and required rates of return on
assets when they are held in well-diversified portfolios. There are eight assumptions underlying the
CAPM’s development and include 1) all investors focus on a single holding period, and they seek to
maximize the expected utility of their terminal wealth by choosing among alternative portfolios on the
basis of each portfolio’s expected return and standard deviation 2) all investors can borrow or lend an
unlimited amount at a given risk free rate of interest and there are no given short sales of any asset 3)
investors have homogeneous expectations. The CAPM assumes that asset returns are jointly normally
distributed random variables but often returns are not normally distributed. So large swings, swings as big
as 3 to 6 standard deviations from the mean, occur in the market more frequently than you would expect
in a normal distribution 4) all assets are perfectly divisible and perfectly liquid 5) there are no transaction
costs 5) there are no taxes 6) all investors are price takers 7) the quantities of all assets are given and
fixed.

To describe a dominate portfolio is to say that it has a better risk return relationship. This means that it
either has high return for the level of risk taken or lower risk for the level of return achieved. Only the
portfolios that fall on the top of the parabola are considered dominant portfolios.

The market portfolio is identified by the presence of a risk free asset by a line drawn from the risk free
asset that is tangent with the efficient frontier. This line represents the set of trading opportunities for all
investors and any combination of the risk free asset and the market portfolio will produce the highest
utility for all market participants. This trading line will dominate all potential portfolios.

The Capital Market line (CML) is a line used in the capital asset pricing model to illustrate the rates of
return for efficient portfolios depending on the risk-free rate of return and the level of risk (standard
deviation) for a particular portfolio. The CML is derived by drawing a tangent line from the intercept
point on the efficient frontier to the point where the expected return equals the risk-free rate of return. In
addition, the CML expresses the current trading terms for risk and return for efficient market
combinations—specifically the risk free asset and the market portfolio.

Sharpe, Litner, Mosin, Treynor and others proposed that looking at total risk was not a correct way of
looking at risk because company-specific risk can be diversified away. Therefore the only risk that should
be priced is that covariance risk. The insight that led Sharpe/Litner/Treynor allowed them to use the
market value weight and the amount invested in asset i, was in the equilibrium, the market portfolio
already has a value weight. Therefore the percent in asset i is excess demand for an individual risky asset
and in a portfolio you can’t have excess demand. They were trying to figure out a min or a max and
anywhere there is a demand for a security is excess.

The main message of the CAPM is the relevant risk of an individual stock is its contribution to the risk of
a well diversified portfolio. The standalone risk of a stock is much greater, then its relevant risk, which is
the contribution to the portfolio’s risk.