Financial Markets Chapter 4

The CAPM and its extensions

Brealey/ Myers/ Allen, Chapter 8, 9

Schredelseker, Kapitel 4.1

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 1 / 30

Capital market theory as a further stage of portfolio theory

Portfolio theory is normative economics: It tells us what people should do

in order to achieve their goals.

Capital market theory is positive economics: It tells us what happens if

people really behave as normative theory suggests.

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 2 / 30

Capital market theory as a further stage of portfolio theory

The core of modern capital market

theory is the Capital Asset Pricing
Model (CAPM), developed in the
sixties by Sharpe, Lintner, and Mossin
Sharpe, W. F. (1964). Capital asset
prices: A theory of market equilibrium
under conditions of risk. The Journal
William F. Sharpe of Finance, 19(3), 425–442.
Nobel price 1990

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 3 / 30

CAPM - basic assumptions

Built on top of portfolio theory, all assumptions made by Markowitz are

taken as well.
But there is a new one:

Homogeneous beliefs
Everyone has the same information and investors analyze and process
information in the same way.

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 4 / 30

CAPM - homogeneous beliefs

Here the two investors have heteroge-

●
neous risk aversion. But they also have
homogeneous beliefs about expected
return, risk and correlations of all
M
●
available stocks. Hence, they derive
the same Markovitz efficient frontier
µ

● and the same tangential portfolio.

Direct consequence
●
rF If this is true for all investors, the
Conservative investor tangential portfolio must be the
Progressive investor
Markovitz efficient frontier market portfolio M.
σ

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 5 / 30

CAPM - capital market line

e
t lin
ke
ar
lm
pit
a µM − rF
Ca µP = rF + σP .
σM
●
M
The slope of the capital market
µ

Equity premium line µMσ−r

M
F
indicates the market
price of risk: It tells us how much
●
more units of expected return an
rF
investor gets for one additional
Risk−free rate
unit of risk.
σ

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 6 / 30

CAPM - capital market line

If you know that in your country

the short term equity premium has been 5% over the last decades.
the average volatility of a stock-market index has been 20% p.a.
today’s money market rate is about 1%
you can estimate the current capital market line as:
0.05σP
µP = 0.01 + .
0.2
In other words:
If you accept 1% more risk (measured as standard deviation), you can
expect to increase your return by 1% × 0.05 ÷ 0.20 = 0.25%.

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 7 / 30

CAPM - The equity premium

Equity Premium - the most important figure in finance (JP Morgan)

Historical equity premium (HEP): historical differential return of the
stock market over treasuries.
Expected equity premium (EEP): expected differential return of the
stock market over treasuries.
Required equity premium (REP): incremental return of a diversified
portfolio (the market) over the risk-free rate required by an investor.
It is used for calculating the required return to equity.
Implied equity premium (IEP): the required equity premium that
arises from assuming that the market price is correct.

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 8 / 30

CAPM - Historical equity premium
0.12

The figure shows historical equity

premia for the US from 1960 to
Historical 40 year EP

2015. Each data point is the trailing

0.08

40-year premium of stocks (SP500)

over treasury bills.
0.04

Data / method see Prof.

Aswath Damodaran’s blog:
0.00

aswathdamodaran.blogspot.de
1960 1970 1980 1990 2000 2010

Year

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 9 / 30

CAPM - Historical equity premium

0.20

Austria
Germany
Japan
Italy
0.15

UK
Historical 20 year EP

USA HEP’s from different countries

are correlated.
0.10

Data: International Equity Risk

Premia Report 2011, Morn-
0.05

ingstar
0.00

1995 2000 2005 2010

Year

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 10 / 30

Equity-premium-puzzle

According to Mehra and Prescott (1985), and many subsequent studies,

the historical premium on equity over bonds cannot be (fully) explained by
systematic risk.

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 11 / 30

CAPM - Expected equity premium

Expected equity premia for several countries gathered by a survey. Best source for this
kind of data is Pablo Fernandez:

Fernandez, P., Linares, P., & Fernández Acı́n, I. (2014). Market risk premium used in 88
countries in 2014: a survey with 8,228 answers. SSRN working paper.

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 12 / 30

CAPM - Expected equity premium

But how are those the expectations formed? The majority of subjects
relies on historical data (Fernandez, Aguirreamalloa, & Avendaño, 2013)

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 13 / 30

CAPM - Required equity premium

Considering the required equity premium, one can ask textbooks.

Fernandez did (Fernandez, 2013).

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 14 / 30

CAPM - Implied equity premium

One way to calculate the implied equity premium (IEP) is given by

rewriting Gordon’s formula to derive the required market rate of return as:
DIV1
r= + g.
S0
Based on overall market performance, researchers generally report IEP’s
around 5%. Major caveat (of course there is one): g must be
approximated by the expected growth rate.

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 15 / 30

How Damodaram calculates IEP

http://aswathdamodaran.blogspot.com/2019/10/
us-equities-resilient-force-or-case.html
Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 16 / 30
CAPM - Implied equity premium

The figure shows implied equity

premia for the US from 1960 to
2018 based on earnings estimates
and the SP 500. Source and further
reading:
Damodaran, A. (2020). Equity risk
premiums (erp): Determinants, esti-
mation and implications - the 2020
edition. SSRN working paper.

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 17 / 30

CAPM - microeconomic foundation

The Markowitz efficient set is

lin
e given by PP 0 . QQ 0 are portfolios
t
ke
lm
ar consisting of M and a single
a P'
pit
Ca Q' stock j:
M
● x=0 Q = xj + (1 − x)M.
x = 0.5
Any portfolio Q will have the
µ

following expected return and

● j x=1 the following risk:
rF
●
µQ = xµj + (1 − x)µM ,
P Q
σQ = (x 2 σj2 + (1 − x)2 σM
2

σ
+ 2x(1 − x)σjM )0.5 .

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 18 / 30

CAPM - microeconomic foundation
Marginal return - How does µ change if you change x?
∂µQ
= µj − µ M .
∂x
Marginal risk - How does σ change if you change x?

∂σQ 2 + xσ 2 + (1 − 2x)σ
xσj2 − σM M jM
= .
∂x σQ

In equilibrium there is no excess demand/supply for j, thus

x = 0 and M = Q.

∂σQ 
 2
σjM − σM
= .
∂x x=0 σM

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 19 / 30

CAPM - microeconomic foundation
In equilibrium the slope of the Q-curve (=marginal rate of substitution
between µ and σ) has to be equal to the slope of the capital market line:

∂µQ ÷ ∂x µj − µ M µM − rF
= 2 = .
∂σQ ÷ ∂x (σjM − σM ) ÷ σM σM

Rearrange and solve for µj :

σjM
µj =rF + (µM − rF ) 2 ,
σM
σjM
and as 2 = βj :
σM

Security market line

µj = rF + (µM − rF )βj .

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 20 / 30

CAPM - the security market line

M L
B S
µB ● Basic and central message:
µM
M
●
The expected return of any
A
risky security (efficient or
µA ●
not) equals the risk free rate
µ

rF ● and a beta-multiple of the

market risk premium. The
market values only systematic
risk (β)! Unsystematic risk
0.0 0.5 1.0 1.5

β
gives no premium because it
can easily be diversified.
Security market line
µj = rF + (µM − rF )βj .

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 21 / 30

CAPM - Betas and characteristic lines

0.05

ri
0.025
●

●
● One way to estimate an asset’s Beta is
●● ● ● ●

●
●
●●
●
●●●●
●
●● ●●●
● ● by using OLS regression on historical
●●●● ●
●●●●
●
●●
● ● ●●●●● ●
● ●●● ●●
●
●
●
●●●●●
● ●● ●
●
● ●
●
●●
●● ●● ● ●●
● ●● ●● ●
●● ●●●
rM data. Consider that Beta is about
●●
●● ● ●
● ●● ●
●● ●●●●●
●● ●● ● ●●
●
●
●
● ●
●●
●
●
●●●
● ●●
●●●●
●●
●
●
●
●
●
●
●
●●
●
●
●●●●
●
●
●
●●
●
●●
●●●
●●
●●
●
●
●●
●
●●●
● ● ●●
●
●●● ●
cyclicality. Thus, we plot (regress)
●
● ● ●●●●●
●● ●●
−0.05 −0.025 ● ●●●● ● 0.025 0.05
●
●
●●
● ●
●● ●
●● ●● ●
●● ●● ●
●
●
● ●
● ●
●
● stock returns against market returns.
● ● ●
●●
Most stocks will tend to move in line
−0.025

●
● ●
●
● with the market - a bullish day for
the market (here: S&P 500) will likely
coincide with a good day for Coca
−0.05

Cola.
Independent variable: SP 500 returns
Dependent variable: Coca Cola returns
ri,t = 0.00017 + 0.66rM,t + i,t

Web App: https://financialmanagement.shinyapps.io/shiny_capm/

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 22 / 30

CAPM - Betas and characteristic lines
●

0.05

ri
●

●● ●
● The regression equation provides:

0.025
●
●
● ●
● ●●●● ●
● ●
●●●●●●
●
●●
●
●● ●●
● ●●
●●
● ●
Jensen’s Alpha, covering the
● ● ● ● ● ●●
●●● ●●
● ●● ●●
●●●●●
●
● ● ●●
● ● ●
average return that cannot be
●
●
●
●
●
●
●
●
●●
●●●
●●●
●
●●●
● ●
● ●● rM
● ● ●
●
●
●●
●
●●
●
●
●
●
●●
●
●
●
●●
●
●
●
●
●
●
●
●
●●
●
●●
●●●●●● ●
●●
●●
●
● ●
●
●
●● explained by market movements
●● ● ●● ●●●● ●
● ●● ●● ●●●
●● ●
−0.05 −0.025 ● ●
● ●
●●●
●●
●
●
●
●
●
● ●●● ●
●●
● ●● ● ●●
●
0.025 0.05 (= overperformance).
●●●●●
●●●
● ●●● ●
●●●
● ●●● ●● Beta, being the slope coefficient
−0.025

●
● ●

●
● ● ●
that is associated to systematic
●●

● ●
● risk.
−0.05

Residuals () that are associated

to unsystematic risk.
Independent variable: SP 500 returns
Dependent variable: Microsoft returns
ri,t = 0.0008 + 1.25rM,t + i,t

Web App: https://financialmanagement.shinyapps.io/shiny_capm/

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 23 / 30

CAPM - Betas and characteristic lines

µi Ex ante every security is repre-

β= sented by a characteristic line:
−0
.5
The higher it’s systematic risk,
β=0
the steeper the line.
rF Note: a security with a negative
0.5 µM
beta will yield a return below
β=
rF
the risk-free rate, even if it has
considerable risk! For further
1
=

1.5

reading, please check

β

2
β=
β=

https://aswathdamodaran.blogspot.co.at/2009/
02/can-betas-be-negative-and-other-well.html
Rearrange SML to get a function µi = f (µM ):
µi = (1 − βi )rF + βi µM .

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 24 / 30

CAPM - CML vs. SML
0.16

0.16
A B A,B
● ● ●

µM C D E µM C,D,E
0.12

0.12
● ● ● ●

F G H I F,G,H,I
● ● ● ● ●
µ

µ
0.08

0.08
0.04

0.04
σM βM
0

0
0 0.05 0.1 0.15 0.2 0.25 0 0.5 1 1.5 2 2.5
σ β

All securities with equal beta must have the same the expected return.
Note, e.g. that A dominates E . That is Ok, since the total risk is not
important in CAPM. What matters is systematic risk, i.e. beta.

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 25 / 30

Practical use of beta

Linear additivity: Beta has become the dominant measure for risky
assets, for single securities or for portfolios as well. For portfolios one can
conveniently calculate weighted average betas:
N
X
βP = xi βi .
i=1

The same method can be applied to aggregate the risk of several projects
of a firm. It will remind you that unsystematic risk will not be
compensated - it’s systematic risk that determines the required return.

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 26 / 30

Practical use of beta

Risk-adjusted (required) return: The CAPM formula provides a proxy

for the risk-adjusted required return. One can use it to figure out the
appropriate discount factor for risky cash flows, e.g. in Gordon’s formula:
DIVi1
Pi = .
rF + (µM − rF )βi − gi

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 27 / 30

Extensions of the CAPM

The CAPM is based on unrealistic assumptions. However, it shows that

the model is quite robust, and that many assumptions can be relaxed:
Black (1972) has shown that a variant of the CAPM can be derived if
there is no constant risk free rate (Zero-beta-CAPM).
Brennan (1971) presented a variant of the CAPM for diverging
borrowing and lending rates.
Merton (1973) developed an intertemporal CAPM.
Gonedes (1976) showed that the basic results of the CAPM hold even
in the case of heterogeneously informed investors.
Lintner (1969) showed that the assumption of unlimited short-selling
possibilities is not necessary.
There are variants with taxes, transaction cost etc.

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 28 / 30

Literature I
Black, F. (1972). Capital market equilibrium with restricted borrowing.
The Journal of Business, 45(3), 444–455.
Brennan, M. J. (1971). Capital market equilibrium with divergent
borrowing and lending rates. Journal of Financial and Quantitative
Analysis, 6, 1197–1205.
Damodaran, A. (2020). Equity risk premiums (erp): Determinants,
estimation and implications - the 2020 edition. SSRN working paper.

Fernandez, P. (2013). The equity premium in 150 textbooks. SSRN

working paper.
Fernandez, P., Aguirreamalloa, J., & Avendaño, L. C. (2013). Market risk
premium used in 82 countries in 2012: a survey with 7,192 answers.
SSRN working paper.
Fernandez, P., Linares, P., & Fernández Acı́n, I. (2014). Market risk
premium used in 88 countries in 2014: a survey with 8,228 answers.
SSRN working paper.
Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 29 / 30
Literature II

Gonedes, N. J. (1976). Capital market equilibrium for a class of

heterogeneous expectations in a two-parameter world. The Journal
of Finance, 31(1), 1–15.
Lintner, J. (1969). The aggregation of investor’s diverse judgments and
preferences in purely competitive security markets. Journal of
Financial and Quantitative Analysis, 4(04), 347–400.
Mehra, R., & Prescott, E. C. (1985). The equity premium: A puzzle.
Journal of monetary Economics, 15(2), 145–161.
Merton, R. C. (1973). An intertemporal capital asset pricing model.
Econometrica: Journal of the Econometric Society, 867–887.
Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium
under conditions of risk. The Journal of Finance, 19(3), 425–442.

Florian Hauser Financial Markets - Chapter 4 Sommersemester 2020 30 / 30