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Derivation of CAPM

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Christopher Ting

Christopher Ting

http://www.mysmu.edu/faculty/christophert/

k: christopherting@smu.edu.sg

T: 6828 0364

ÿ: LKCSB 5036

Portfolio Construction, Expected Return

expected return ri := E ri,t and 1 − w portion invested

in the

market portfolio of expected return rm := E rm,t .

combination of ri,t and rm,t .

• By the linear property of the expectation operator E · , the

expected return of this portfolio is

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 .

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)

Slope of CML

have

rm − rf drw

=

σm dσw w=0

rw 6

CML

"

"

"

"

"

rm "

"

"

"

"

"

rf "

σ-

w

σm

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

Christopher Ting QF 302 Week 6 February 10, 2017 5/7

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

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

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.

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

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