Part III:

Equilibrium in Capital Markets

based on: INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN
a) Capital Asset Pricing Model

based on: INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN
 Motivation

• So far we learned that under certain assumptions

(e.g., normal distribution of asset returns) investors
hold efficient portfolios which are determined only
by risk (variance) and return
– But portfolio theory only looks at individual investors: each
investor decides according to his/her preferences
– Nothing has been said about equilibrium in the capital
market, i.e., what happens if we have many investors and
bring them together in a capital market
• CAPM introduces the idea of equilibrium and can
thus tell us which asset prices will result if market
participants invest in efficient portfolios according
to Markowitz

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 Capital Asset Pricing Model
(CAPM)

• It is the equilibrium model that underlies all

modern financial theory
• Derived using principles of diversification
with simplified assumptions
• Markowitz, Sharpe, Lintner and Mossin are
researchers credited with its development

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 Assumptions

Some of these assumptions may be relaxed in more complex

versions of the model, but not all!
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 Portfolio Choice in Equilibrium

• Remember:
– All investors will hold efficient portfolios along the CAL(P)
from the risk-free asset to the tangency portfolio P
• As investors have homogenous expectations all
hold a risky portfolio with an identical structure
– Only the mix between the risky PF and risk free asset is
different according to preferences
• In order to have equilibrium on the capital market,
the tangency portfolio has to contain all assets
– Therefore, the risky portfolio has to be the same as the
market portfolio, i.e., the portfolio of all risky assets
available in an economy
– The market portfolio is then the portfolio of all risky assets
which is completely diversified
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 Resulting Equilibrium Conditions

• All investors will hold the same portfolio for

risky assets – market portfolio
• Market portfolio contains all securities and
the proportion of each security is its market
value as a percentage of total market value
• Risk premium on the market depends on the
average risk aversion of all market
participants
• Risk premium on an individual security is a
function of its covariance with the market

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 The Efficient Frontier and the
Capital Market Line
The Capital Market Line (CML) is the Capital Allocation Line (CAL)
constructed with the risk-free asset and the market portfolio

Equilibrium

P: Optimal risky PF / tangency PF M: Market PF

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 Market Risk Premium

• The risk premium on the market portfolio will be

proportional to its risk and the degree of risk
aversion of the investors
𝐸 𝑟𝑚 −𝑟𝑓
– Remember: 𝑦 = 2
𝐴𝜎𝑚

– In the simplified CAPM economy, any borrowing position

must by offset by the lending position of the creditor
• Net lending and borrowing across all investors must be zero
• Average position in risky portfolio is 100%
– Thus, using the average risk aversion 𝐴 we get for the
average risky position 𝑦
𝐸 𝑟𝑚 −𝑟𝑓
• 𝑦=1= 2
𝐴𝜎𝑚

– Risk premium on the market portfolio then equals:

2
• 𝐸 𝑟𝑚 − 𝑟𝑓 = 𝐴𝜎𝑚
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 Return and Risk For Individual
Securities
• The risk premium on individual securities is a
function of the individual security’s contribution to
the risk of the market portfolio.
– This is driven by covariance of returns with the assets that
make up the market portfolio.
• How can we measure an individual security’s, say
GE’s, contribution to the market portfolio?
– Variance of the MP: w1 ... wGE ... wn

w1 COV(r1,r1) ... COV(r1,rGE) ... COV(r1,rn)

... ... ... ... ... ...

wGE COV(rGE,r1) ... COV(rGE,rGE) ... COV(rGE,rn)

... ... ... ... ...

wn COV(rn,r1) ... COV(rn,rGE) ... COV(rn,rn)

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 Return and Risk For Individual
Securities
• GE’s contribution to variance of MP
– 𝑤𝐺𝐸 𝑤1 𝐶𝑜𝑣 𝑟1 , 𝑟𝐺𝐸 + … + 𝑤𝐺𝐸 𝐶𝑜𝑣 𝑟𝐺𝐸 , 𝑟𝐺𝐸 + … + 𝑤𝑛 𝐶𝑜𝑣 𝑟𝑛 , 𝑟𝐺𝐸
= 𝑤𝐺𝐸 𝐶𝑜𝑣 𝑟𝐺𝐸 , 𝑟𝑀
• Proof
𝑛
– 𝑟𝑀 = 𝑘=1 𝑤𝑘 𝑟𝑘
𝑛 𝑛

𝐶𝑜𝑣 𝑟𝐺𝐸 , 𝑟𝑀 = 𝐶𝑜𝑣 𝑟𝐺𝐸, 𝑤𝑘 𝑟𝑘 = 𝑤𝑘 𝐶𝑜𝑣(𝑟𝑘 , 𝑟𝐺𝐸 )

𝑘=1 𝑘=1
– This is exactly the same as the term in brackets above
• GE’s contribution to risk premium of MP
– 𝑤𝐺𝐸 [𝐸(𝑟𝐺𝐸 ) − 𝑟𝑓 ]

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 Return and Risk For Individual
Securities
• Reward-to-risk for GE
GE′s contribution to risk premium 𝑤𝐺𝐸 [𝐸(𝑟𝐺𝐸 ) − 𝑟𝑓 ] 𝐸(𝑟𝐺𝐸 ) − 𝑟𝑓
= =
GE′s contribution to variance 𝑤𝐺𝐸 𝐶𝑜𝑣 𝑟𝐺𝐸 , 𝑟𝑀 𝐶𝑜𝑣 𝑟𝐺𝐸 , 𝑟𝑀
• Reward-to-risk for MP
– “market price for risk”
Market risk premium 𝐸(𝑟𝑀 )−𝑟𝑓
– =
Market variance 2
𝜎𝑀

• Equilibrium
– all investment opportunities must offer the same reward-
for-risk ratio
– Otherwise, investors would rearrange their PF
– Prices would adjust until equilibrium is reached again

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 Return and Risk For Individual
Securities
• Equilibrium
𝐸(𝑟𝐺𝐸 )−𝑟𝑓 𝐸(𝑟𝑀 )−𝑟𝑓
– = 2
𝐶𝑜𝑣 𝑟𝐺𝐸 ,𝑟𝑀 𝜎𝑀
𝐶𝑂𝑉 𝑟𝐺𝐸 ,𝑟𝑀
– 𝐸 𝑟𝐺𝐸 − 𝑟𝑓 = 2 [𝐸 𝑟𝑀 − 𝑟𝑓 ]
𝜎𝑀

• The green term

– is the contribution of GE to the variance of the MP as a
fraction of the total variance of the MP
– We call this also beta
– Restating gives the expected return-beta relationship:
– 𝐸 𝑟𝐺𝐸 = 𝑟𝑓 + 𝛽𝐺𝐸 [𝐸 𝑟𝑀 − 𝑟𝑓 ]
– Thus, the required return depends on the risk-free rate,
beta, and the risk premium of the market portfolio

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 Return and Risk For Individual
Securities
• In general: 𝐸 𝑟𝑖 = 𝑟𝑓 + 𝛽𝑖 [𝐸 𝑟𝑀 − 𝑟𝑓 ]
• Combinations of assets: Portfolio P with k stocks
E (rP )   wk E (rk ) and
k

 P   wk  k
k

– The portfolio beta is simply the weighed sum of the betas

of all assets
– The expected return-beta relationship also holds for the
market portfolio:
E (rM )  rf   M  E (rM )  rf 
– As beta = 1 for the market portfolio, this must be true

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 The Security Market Line

Cyclical stock

Defensive stock

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 The Security Market Line

• The SML can be used to as a benchmark for

investment evaluation
– Given the beta of an asset, the SML gives the required
return to compensate for the risk
– Thus, fairly priced assets plot on the line
• What if an asset is not on the SML?
– Below SML: lower than required rate of return, overpriced
asset, negative alpha
– Above the SML: higher than required rate of return,
underpriced asset, positive alpha
• In equilibrium, all assets must lie on the SML
– This means that the required rate of return equals the
expected rate of return

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The Security Market Line
• Beta: 1.2, rf = 6%, E(rm) = 14%
• Required return: 6% + 1.2(14%-6%)=15.6%
• An investor believes the expected return is 17%  Alpha of 1.4%

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 Practitioners View – First
Thoughts
• What if not everyone holds the MP in reality?
– As long as investors hold highly diversified portfolios, which
are highly correlated with the MP, the results still
approximately hold
• What if the assumptions are relaxed?
– Some assumptions are not critical, e.g, taxes or the
existence of a risk-free asset
• Does the CAPM imply that well and poorly managed
firms have the same returns?
– Well, not for accounting returns of the firm
– For expected security returns, this plays no role as the
current stock price already reflects that it is a poorly/well
managed firms

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 Is the CAPM Practical?

• Like most other models, the CAPM is a

simplification and far from being perfect
• Nevertheless, the CAPM is the best model to
explain returns on risky assets we have.
• We must use a proxy for the market portfolio.
• CAPM is widely accepted and used in practice.

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 Applications of the CAPM

• In general, the CAPM tells us the required rate of return for a

risky asset, depending on its beta risk
– Thus, the CAPM can be used to find a correct discount rate for risky cash
flows if we know the beta of this asset
• Firm valuation
– Companies will usually be financed by equity as well as bonds, then we
have to use the Weighted Average Capital Costs for discounting
– WACC = weighted average of equity costs and debt costs
– The CAPM can tell us something about the equity part
• Capital budgeting
– Cost of equity can be helpful to calculate the NPV of planned projects
• Investment valuation
– The required rate of return, given the beta risk of a security, can be used
as a benchmark
• Legal settings
– SML can help to find a risk-appropriate compensation
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 Is the CAPM Testable?

• Two basic predictions:

1. market portfolio is efficient
2. the SML describes the risk-return trade-off
• Since (2) follows from (1), the optimal test for the CAPM
would analyze whether the market portfolio is risk-return
efficient
• The market portfolio, however, is unobservable!
– Includes all risky assets that can be held by investors
– Thus far more extensive than an equity index and also include bonds, real
estate, private firms, ...
– Many of these assets are highly illiquid or even non-traded and prices are
thus not reliable or observable
• Thus, empirical tests mainly focus on (2)
• See Fama/French 2004 for more information!

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Is the CAPM Testable? –
Fama/French 2004

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Is the CAPM Testable? –
Fama/French 2004

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 Is the CAPM Testable? –
Roll’s Critique
• Roll (1977) argued that empirical tests of the CAPM suffer
from potential misspecification
– As the true market portfolio is unobservable, actually, it is only tested
whether the market index used as a proxy is ex-post risk efficient
• Roll proved that the SML-equation holds for every risk efficient
portfolio, i.e., returns depend linearly on any beta measured
relative to a risk efficient portfolio
– Hence, rejecting the CAPM could be simply due to the fact that the market
index is not risk efficient
– Detecting a linear relationship between returns and the beta only implies
that the market index used is risk efficient
• Empirically, however, it has been shown that the CAPM is
relatively robust with respect to the choice of the market
index (e.g., Stambaugh 1982)

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 Extensions of the CAPM

• Zero-Beta CAPM
– Assume there is no risk-free asset: does CAPM still work?
– Idea: find so called zero-beta portfolio: portfolios that are uncorrelated
with market portfolio
– All zero-beta portfolios must have same return
– Now combine zero-beta portfolio and market portfolio
• Background
– Merton and Roll showed that each PF on the efficient frontier (except the
global minimum variance PF) has a “companion” PF on the bottom
(inefficient) half of the frontier with which it is uncorrelated
– This companion PF of the MP is the zero-beta PF, called Z
• CAPM equation
– Fisher Black showed that the basic CAPM equation holds in a modified
form:
– 𝐸 𝑟𝑖 = 𝐸 𝑟𝑧 + 𝛽𝑖 [𝐸 𝑟𝑀 − 𝐸 𝑟𝑍 ]

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 Extensions of the CAPM

• Consideration of labor income and non-traded assets

– Huge relative importance of labor income
• Multi-period models
– Merton’s Intertemporal CAPM
• Consumption-based CAPM
– Rubinstein, Lucas, and Breeden
– Investors allocate wealth between consumption today and investment for
the future
• Liquidity: The ease and speed with which an asset can be sold
at fair market value
– Illiquidity Premium: Discount from fair market value the seller must
accept to obtain a quick sale.
– Measured partly by bid-asked spread

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Other Extensions of the CAPM –
Liquidity premium

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 CAPM and Investment Industry

• Investment Industry
– Mostly relies on the single-index CAPM model
– Most investors don’t beat the index portfolio

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 Masters of Finance: William F.
Sharpe
https://www.youtube.com/watch?v=PfVaOn9W3mo

Especially 3:05

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