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A Super Simple Derivation of CAPM

Christopher Ting

Christopher Ting
http://www.mysmu.edu/faculty/christophert/
k: christopherting@smu.edu.sg
T: 6828 0364
ÿ: LKCSB 5036

February 10, 2017

Christopher Ting QF 302 Week 6 February 10, 2017 1/7


Portfolio Construction, Expected Return

• Consider a portfolio with w portion invested in an asset i of



expected return ri := E ri,t and 1 − w portion invested
 in the
market portfolio of expected return rm := E rm,t .

• The return of this portfolio, denoted by rw,t , is a weighted


combination of ri,t and rm,t .

rw,t = wri,t + (1 − w)rm,t (1)



• By the linear property of the expectation operator E · , the
expected return of this portfolio is

rw = wri + (1 − w)rm . (2)

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Variance of Portfolio’s Return

· . Consequently,
• To (1), apply the variance operator V

2 2
   
V rw,t = w V ri,t + (1 − w) V rm,t + 2α(1 − α) C ri,t , rm,t .

• For convenience, we denoe


2 := σi2 := V ri,t 2 =
  
§ σw V rw,t , and σm V rm,t

§ The covariance σim := C ri,t , rm,t .

• With these notations, the variance V rw,t simplifies to

2
σw = w2 σi2 + 2w(1 − w)σim + (1 − w)2 σm
2
(3)

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Slope of CML

1 The slope of the CML is the Sharpe ratio. At w = 0, or for σm , we


have
rm − rf drw
=
σm dσw w=0
rw 6
CML
"
"
"
"
"
rm "
"
"
"
"
"
rf "
σ-
w
σm

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Derivation of Slope
drw
1 It is tedious to compute directly.
dσw
2 Instead, we have, by chain rule,
drw
drw
= dw
dσw dσw
dw
drw
3 From (2), we obtain = ri − rm
dw
4 From (3), we obtain
dσw
2σw = 2ασi2 + 2(1 − 2w)σim , −2(1 − w)σm
2
dw
equivalently
dσw ασi2 + (1 − 2w)σim − (1 − w)σm
2
=
dw σw
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Slope at w = 0
1 Putting everything together,

drw
drw ri − rm
= dw = 2 2
dσw dσw ασi + (1 − 2w)σim − (1 − w)σm
dw σw
2 At w = 0, σw = σm . Moreover, given that the slope is the Sharpe
ratio, we have
rm − rf ri − rm
= 2

σm σim − σm
σm
ri − rm ri − rm
rm − rf =  2
= 
σim − σm σim
2 2
− 1
σm σm
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Slope at w = 0 (Cont’d)
σim
3 For any asset i that is not a market portfolio, 2
− 1 6= 0. So we
σm
multiple it to both sides to obtain
 
σim
(rm − rf ) 2
− 1 = ri − rm
σm
σim
2
(rm − rf ) − (rm − rf ) = ri − rm
σm
σim
4 Knowing that 2
= βi , we write,
σm

βi (rm − rf ) = (rm − rf ) + ri − rm = ri − rf
5 Hence CAPM ensues:

ri − rf = βi (rm − rf )
q.e.d.
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