Capital Asset Pricing Model

(CAPM)

1
 Introduction
• The model was developed by Sharpe (1963,
1964), Treynor (1961).

• CAPM is a one-period equilibrium model that

shows that the equilibrium rates of return on all
risky assets are a function of their covariance
with market portfolio.

• It is a useful model that quantifies and prices

risk.

2
• The model assumes that most investors diversify their
investment holdings so as not to “put all of their eggs in one
basket”.

• In a CAPM context, the only type of risk that is rewarded/

relevant in the risk-return trade-off is the undiversifiable or
market-related risk.

• Thus, under CAPM, the additional risk created by not

diversifying among investments is not rewarded by the
securities markets.

3
• The measurable relationship between risk and expected
return in the CAPM is summarized by the following
expression:
R  R  (R R )
i f i m f
 im Cov( Ri , Rm )
• Where, i   
m 2
Var ( Rm )

• The CAPM equation is equal to the risk-free rate of return (Rf)

plus the market-wide risk premium of (Rm - Rf) that is required
to coax investors away from exclusive investment in risk-free
securities.

• OR:
• Expected Return = reward for waiting + reward for bearing risk

• Security expected return = risk free rate + risk premium. 4

• The beta coefficient measures the riskiness of a given
asset or portfolio relative to the overall market
benchmark.

• Beta expresses how much the given investment’s

returns tend to vary as the returns on the benchmark
market index vary over the business cycle.

• Beta therefore may be viewed as the appropriate weight

to apply to the marketwide risk premium (Rm - Rf ).

• Beta of the market portfolio must, by definition, be equal

to 1.

5
Economic Rationale of the CAPM Equation
• The rationale for the CAPM equation is the simple
observation that investors must be persuaded to move
their money from riskless assets like SA Treasury bonds
into risky assets.

• Suppose investors can obtain a 7% return on a TB. They

will not invest in a market portfolio of risky assets unless
they are compensated accordingly.
•
• Investors would want an expected return that is greater
than 7% if material risk is present. The usefulness of
CAPM is in measuring how much of an expected return
premium is appropriate for investments in light of their
riskiness relative to the risk of a benchmark broad market
index. 6
•
 Example
Assume the following:
• The risk-free rate of return on a treasury bill = 7%
• The expected return on the market = 15%,
• An investor wants to determine the appropriate expected
rate of return on a stock with a beta of 1.5.

• Thus market-wide risk premium = Rm - rf = 15% - 7% = 8%.

•
• This implies that investors will not allocate money to
investments with market-like riskiness unless they can
expect to get at least an 8% premium over the risk-free rate
of 7%.

7
• However, an 8% premium will be insufficient if an
investment is more variable (i.e., riskier) than the overall
market.

• The returns on a stock with a beta of 1.5 tend to vary 1.5

times more than the return on the overall market.

• The market-wide risk premium of 8% must therefore be

increased 1.5 times to 8 x 1.5 = 12% in order to attract
investors.

• Thus, a stock with a beta of 1.5 should generate an

expected return equal to:
• Ri = rf + bi(rm - rf) = 7 + 1.5(15 - 7) = 19%
8
 The standard CAPM Assumptions
1. Markets are frictionless, and information is costless and is
simultaneously available to all investors. Because markets are
frictionless the borrowing and lending rates are equal. This also
helps us to derive a linear capital market line.

2. Investors are risk averse and seek to maximize the expected utility
of wealth. Investors are expected to make decisions solely in terms
of expected values and standard deviations of the returns on the
portfolios.

3. Investors are price-takers and have homogeneous expectations

about asset returns. The assumption of homogeneous expectations
implies that all investors make decisions based on an identical
opportunity set. That is, no one can be fooled since everybody has
the same information at the same time.
The assumption that individuals are price-takers implies that an
individual cannot affect the price of a security by his buying or
selling actions.

9
 Assumptions
4. Assets are infinitely divisible – this means that
investors can take any position in an investment
regardless of the size of their wealth.

5. Unlimited short sales are allowed.

6. Unlimited lending and borrowing at the riskless

rate.

7. All assets are marketable.

10
 Derivation of the CAPM
• Let M be the market portifolio, I the risky asset
and Rf the risk free rate.

• If market equilibrium is to exist, price of assets

must adjust until all are held by investors.

• Or there can be no excess demand (that is,

demand for assets = supply of assets).

• The equilibrium proportion of each asset in the

equilibrium market portfolio must be:
market value of the individual asset
wi 
Market value of all assets 11
 The Capital Market Line
Rp CML

Rm
M I

Rf

I’
0 m p
12
 Suppose we have a portfolio with one risky asset (asset I)
and a market portfolio M. Suppose that a% of the wealth is
invested in asset I and the remainder (1-a)% in the market
portfolio.
Portfolio return: Rp  aRi  (1  a) Rm
E ( Rp )  aE ( Ri )  (1  a) E ( Rm )

  a   (1  a)   2a(1  a) im
2
p
2
i
2 2 2
m

 p  a   (1  a)   2a(1  a) im
2
i
2 2 2
m

13
The change in the mean and standard deviation with respect to
a (% invested in I) is determined as:

E ( R p )
 E ( Ri )  E ( Rm ) and
a
 p 1
   2a 
1

 a 2 i2  (1  a)2  m2  2a(1  a) im 2 2
 2 m2  2a m2  2 im  4a im
a 2
i

But in equilibrium excess demand for any asset is zero, that

is, a = 0. Thus we can calculate: E ( R p )  p
and
a a 0 a a 0

E ( R p )
 E ( Ri )  E ( Rm ) and
a a 0
 p  
   2 m2  2 im   im 14m

1 2
1 2 
 m 2
a a 0
2 m
 Thus the slope of the risk-return trade-off evaluated at M, in
equilibrium, is:
E ( R p )
a E ( Ri )  E ( Rm )

 p  im   im2
a a 0 m
But at M the slope of opportunity set II’ = slope of the market line
Rm  R f
Recall slope of capital market line is =
m
Equating the above slopes yields:

E ( Ri )  E ( Rm ) Rm  R f

 im   im
2
m
m
15
 Making E(Ri) the subject:
 im   m2
E ( Ri )  E ( Rm ) Rm  R f
  E ( Ri )  E ( Rm ) 
m

Rm  R f 
 im   m m
2 2

m
  im 
 E ( Ri )  E ( Rm )   2  1 Rm  R f  
 m 
  im 
 
 E ( Ri )  E ( Rm )   2  Rm  R f  Rm  R f 
 m 

  im 
 
 E ( Ri )  Rm   2  Rm  R f  Rm  R f
 m 
  im 
 E ( Ri )  R f   2  Rm  R f  
 m 

 E ( Ri )  R f  i Rm  R f    im Cov( Ri , Rm )
Where  i  2 
m Var ( R16m )
The CAPM equation above can be written as:

Expected return on the ith security = risk free rate + risk premium.

The risk premium is the price of risk multiplied by quantity of


risk (βi). Beta of security i is:  i  im2
m
Beta of a Portfolio
The beta of a portfolio βp is a linear combination of individual
asset betas. That is,
n n
 p  w11  w2  2  .....  wn  n   wi i , where  w i  1
i 1 i1

17
Proof:
Consider a portfolio with two assets, X and Y.
We want to show that βp=aβX+ bβY

The return for the portfolio is: Rp=aX+bY. So E(Rp) = aE(X)+bE(Y)

 im Cov( R p , Rm )
Now, i  2 and so p 
m  m2

18
 Re call : Cov( Rp , Rm )  E[ Rp  E ( Rp )][Rm  E ( Rm )]

 E[aX  bY  E(aX  bY )][Rm  E( Rm )]

 E[aX  bY  aE( X )  bE(Y )][Rm  E( Rm )]
 E[a( X  E( X ))  b(Y  bE(Y ))][Rm  E( Rm )]

 aE[( X  E( X ))( Rm  E( Rm ))  bE[(Y  E(Y ))](Rm  E( Rm ))]

 aCov( X , Rm )  bCov(Y , Rm )
Dividing the above by variance of the market portfolio yields:
Cov( R p , Rm ) aCov( X , Rm )  bCov(Y , Rm ) aCov( X , Rm ) bCov(Y , Rm )
  
 m2  m2  m2  m2

So,  p 
aCov( X , Rm )

bCov(Y , Rm )
 a x  b y
 2
m  2
m 19
This can be generalized to the case of N-assets to get:
n
 p  w11  w2  2  .....  wn  n   wi i
i 1

20
 CAPM for a Portfolio
E (ri )  rf   i [ E (rm )  rf ]
M ultiplying throughout by wi yields
wi E (ri )  wi rf  wi  i [ E (rm )  rf ]
 w E (r )   w r   w  [ E (r
i
i i
i
i f
i
i i m )  rf ]

Note that :
 w E (r )  E (r )
i
i i p

wr
i
i f  rf  wi  rf sin ce
i
w i
i  w1  ...  wn  1

 
i wi i [ E (rm )  rf ]   i wi i [ E (rm )  rf ]
 
  wi  i   w11  ........  wn  n   p
 i 
E (rp )  rf   p [ E (rm )  rf ] 21
The Capital Market Line (CML) vs. the Security Market Line
• CML – a line plotting the expected return against total risk.
• SML – a line plotting expected return against market risk (or
beta). SML is the line corresponding to the CAPM.
•
• Because the SML is linear the graphical representation of
CAPM in the (β, E(Ri)) plane has two main points [0, Rf] and
[1, E(Rm)].

• The point [0, Rf] corresponds to a zero beta and risk free rate
of return and is the y-intercept.

• The point [1, E(Rm)] corresponds to a beta of 1 and the

market return and is the tangency point of the mean-
variance portfolio of the CML. 22
•
 The CML vs. SML
Rp Ri
SML
CML

M Rm
Rm M

A B C
RA
Rf Rf

0 m p 0
A m  1 i
23
• In equilibrium all assets will be priced so that they lie on
the SML.
• Similarly, all efficient portfolios will be priced so that they
lie on the CML.
• Inefficient portfolios will not lie on the CML but will still be
priced in equilibrium to reflect only the undiversifiable risk
contained in them.
• A, B and C have the same return but different total risks.
But because they have same expected return they must in
equilibrium have the same level of diversifiable risk.
• The fact that the 3 assets have different total risks is
irrelevant for determining their equilibrium prices or
returns. This is because the total risk contains a
diversifiable component that will not be paid for in
equilibrium.
24
 Alpha
• Alpha measures the excess return on a
security.

• Alpha = actual rate of return on a security less required rate

of return using CAPM.

• That is:
i  ri  ri where r  rf  (rm - rf )i

25
If:

1. αi = 0, then the security is correctly priced.

2. αi > 0, the security is underpriced (or oversold) – the

security is expected to rise in price and so worth buying.

3. αi < 0, the security is overpriced (overbought) – the

price of the security is expected to fall so it worth
selling.

26
 Alpha

Ri
20 A

SML

18

15
M=Market

12

7
6 B

0 0.5 1 1.5 βi
27
• To demonstrate why a point above the SML implies an
underpriced asset one can convert the CAPM equation,
which is typically expressed in terms of rates of returns,
into an equation expressed in terms of prices.
• Let ri be the rate of return of asset i so that ri = (Vi – Pi)/Pi,
where Pi is the observed price of asset i (i.e. the price at
which the asset was bought) and Vi is the uncertain
payoff for asset i.
• Generally asset return is: ( P  P )  ( Div)
ri  e i

Pi
Pe  Div  Pi
ri 
Pi
28
 Vi  Pi
ri  , where Vi  Pe  Div
Pi
Vi  Pi
ri 
Pi
E (Vi )  Pi E (Vi )
 E (ri )   1
Pi Pi
 but E (ri )  rf   i (rm  rf )
E (Vi )
so r f   i (rm  rf )  1
Pi
E (Vi )
  1  rf   i (rm  rf )
Pi
E (Vi )
 Pi 
1  r f   i (rm  rf )
E (Vi ) Cashflows
 Pi  
1  E (ri ) 1  E (ri )
29
 Aggressive and Defensive Stocks
Ri

18 A = Aggressive
Stock

15
M=Market

12 D = Defensive Stock

0 0.5 1 1.5 30i

 CAPM Extensions
• 1. Differential Borrowing and Lending Rates

• One CAPM assumption is that the lending rate = borrowing

rate. i.e., investors can lend or borrow unlimited amounts at
the risk free rate. What happens if the two rates are not
equal?

• Because of the different rates the CML is no longer a straight

line and we also no longer have a single unique market
portfolio.

31
32
• The CML is now rfZVG. The segment rfZ indicates the
investment opportunities available when an investor
combines risk-free assets (that is, lending at the risk-free
rate rf) and the portfolio Z on the frontier.

• It is not possible to extend this line further if it is assumed

that you cannot borrow at this risk free rate. If we assume
that you can only borrow at rb the point of tangency from
this rate would be on the curve at point V.

• This indicates that you can borrow at rb and use the

proceeds to invest in portfolio V to extend the CML along
the segment VG. The CML is now the curve rfZVG.
•
33
 2. Transaction Costs
• The assumption of zero transaction costs implies that
investors will buy or sell mispriced securities until they
again plot on the SML.

• In the presence of transaction costs all mispricing may not

be corrected because sometimes the cost of buying and
selling the mispriced securities may offset benefits of selling
or buying a mispriced security.

• Therefore it is possible for securities not to lie on the SML

but rather very close to it. The SML will be a band of
securities rather a single line. The width of the band is a
function of the amount of the transaction costs.
34
35
3. Heterogeneous Expectations and Planning Periods

• If all investors had different expectations about risk and

return each would have a unique CML and SML.

• The composite graph would be a set (band) of lines with a

width determined by the divergence of the expectations.

• If all investors have similar information and background, the

band would be narrower than if they had very different
backgrounds and very large degree of information
asymmetry among them.

36
3. Taxes
• The simple form of CAPM assumes away taxes. The
rates of return that we used throughout the model were
pre-tax returns. The implication of this assumption is that
investors are indifferent between receiving income in the
form of capital gains or dividends and that all investors
hold the same portfolio of risky assets.
• If we recognize the existence of taxes and also the fact
that, in general, capital gains tax is lower than tax on
dividends, the equilibrium prices should change.

• Investors should judge their returns after, and not before,

tax.
• The rates of return that we used throughout the model
were pretax returns:
37
• The rates of return that we used
throughout the model were pretax returns:

( Pe  Pb )  ( Div)
E ( Ri ) notax 
Pb
Where:
• Pe = ending price
• Pb = beginning price
• Tcg = tax on capital gain or loss
• Div = dividend paid during the period
• Ti = tax on ordinary income
38
The actual returns for most investors are affected
as follows:

( Pe  Pb )  ( 1  Tcg )  ( Div )  ( 1  Ti )
E( Ri )aftertax 
Pb

39
• The introduction of taxes in the CAPM framework can
also affect our expected outcomes from the model
because the individuals that were assumed to face no
tax are now faced with taxes.

• These tax rates differ from individual to individual and

from institution to institution.

• For individuals or institutions that do not pay taxes the

original pretax CAPM model is correctly specified.

• The different tax rates can result in differences in CML

and SML among investors.

40
 CAPM Empirical Tests
• Recall the CAPM in its ex-ante form is stated as follows:

E( R j )  R f  [ E( Rm )  R f ]  j
• Does CAPM fit observed data well?
• A number of questions have been raised including:

– Whether the model should be estimated as a linear model.

– Whether it is correct to assume that beta is the only factor affecting

returns.

– Whether rf is the appropriate risk-free rate.

– Etc
41
 Conducting a CAPM Test
• In order to conduct an empirical test of the CAPM we start by
transforming the CAPM equation from its ex-ante form to its
ex-post form.
• The ex-ante form is the expression of the CAPM that uses
expectations (that is, the expression E(ri) = rf+bi[E(rm)-rf]).

• Expectations cannot be measured.

• The ex-post form uses observed data. We shall assume that

the returns are normally distributed and that capital markets
are efficient in the fair game sense.
• The transformation is done by assuming that the rate of
return on any asset is a fair game. I.e., on average the
realized rate of return on an asset is equal to the expected
42
rate of return.
Let’s write the fair game as follows:

43
 Recall CAPM gives us: E( R j )  R f   j [ E( Rm )  R f ]
Substituting CAPM equation into the fair game expression
yields:
R jt  R ft   j [ E( Rmt  R ft ]   j mt   jt
R jt  R ft   j E ( Rmt )   j R ft   j mt   jt
Substituting  mt  Rmt  E ( Rmt ) into the above equation yields:
R jt  R ft   j E ( Rmt )   j R ft   j [ Rmt  E ( Rmt )]   jt

 R jt  R ft   j E ( Rmt )   j R ft   j Rmt   j E ( Rmt )   jt

 R jt  R ft   j R ft   j Rmt   
jt R jt  R ft  [ Rmt  R ft ] j   jt
 R jt  R ft  [ Rmt  R ft ] j   jt ..............................( A)

This is the ex-post form of CAPM. It is expressed in terms of ex-

post observations of return data instead of ex-ante expectations.
44
0 If we let Rpt  Rpt  R ft and  1  Rmt  R ft the equation **
becomes:

Rpt   0   1 p   pt ………..……………………………..(B)

The only difference between equation (A) and equation (B) is

that we have added a constant ( 0 ) in equation (B). When
the CAPM is tested it is usually expressed as in equation (B).

45
• BUT!!!!!!!!!
• But before you run equation (B) you need to calculate
the beta for each firm in the sample.

• To do that run equation (A) for each firm.

•
• Equation (A) is a time series equation and it is called the
first-pass regression.
•
• Having calculated the betas – go ahead and run B using
the betas from A. This second equation uses cross
section data and is called the second-pass regression.

46
 Predictions tested by CAPM
1. The intercept,  0 , should not be significantly different
from zero. That is, if you run your CAPM regression
(equation 17) the intercept should be insignificant.

2. Beta should be the only factor that explains the rate of

return on the risky asset. If you include other variables in
the model their coefficients should be insignificant.

47
3. Beta enters the model linearly. If you modify the model
and include beta squared, cubed, etc. the coefficients on
those terms should be insignificant. That is, instead of
running the regression using (17) one can run the
following equation:
Rpt   0   1 p   2  p2   3 p3   4  p4   pt

• So if CAPM holds then the coefficients of the nonlinear

components of the equation must be insignificant.

4. The coefficient of beta should be Rmt - Rft.

• When estimated over long periods of time, the rate of
returns on the market portfolio should be greater than
the risk free-rate. Recall the market portfolio is riskier
than the government treasury bill, for example. 48
 Empirical Evidence
• A lot of research has been done trying to test the validity of
CAPM.
• See for example Fama and French (1992), Fama and
Macbeth (1973), Basu (1977) Gibbons (1982).

• Make own notes based on the studies: Fama and French

(1992) and Fama and Macbeth (1973).

• Your notes must include the following:

– How the studies were done –methodology used
– Findings of the study
– Period of study (sample period)
– Firms covered – which sectors were covered, from which country
were the firms selected, etc.
– Weaknesses of the study. 49