Finance 70391

Topic 9: The Capital Asset Pricing Model

Prof. Tetiana Davydiuk

CMU – Tepper School of Business

Fall 2021
Outline

Introduction

Capital Asset Pricing Model

CAPM and opportunity cost of capital

Appendix: Portfolio betas

Appendix: Does CAPM work?

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Big Picture

Where did the opportunity cost of capital come from?

It is the expected return that investors require given the risk inherent in
the cash flows

It is the discount rate that we use to arrive at net present value

T
X CFt
N P V0 = t
t=0 (1 + r∗ )

It is the discount rate that we use to arrive at firm value

T
X F CFt
F irm V alue =
∗ t
t=1 (1 + r )

We know how to measure cost of capital for two cases:

1. Zero risk
2. Risk matches market portfolio
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What is Risk?
Example #1:

1. A “risk-free asset:” $110 one year from now costs $100 today
Risk-free rate is 10%
Rate of return is (trivially) 10%

2. A “lottery” (“gamble,” “risky asset”):

1 $120
2

1
2 $100

If cost is $100, expected return is 10%

We call this “risk neutrality”

If cost is $95, expected return is 15.7%

Excess expected return – the risk premium – is 5.7%
We call this “risk aversion”

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What is Risk?

The risk in an asset is manifested in a positive risk premium

Risk premium = E [r̃i − rf ] >0

| {z }
excess return

Equivalently, an asset is “risky” if its expected return is greater than the

risk free interest rate

What is the risk premium on a riskless asset?

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Outline

Introduction

Capital Asset Pricing Model

CAPM and opportunity cost of capital

Appendix: Portfolio betas

Appendix: Does CAPM work?

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Foundations of CAPM

Given:

1. Investors prefer to hold well-diversified portfolios

By picking assets with ρ < 1, we can reduce the total risk of our portfolio

2. There is a limit to diversification

There is a limited number of traded assets that investors can invest in

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Types of Risk

The standard deviation of a portfolio return measures the total (overall)

risk of investing in that portfolio of stocks

The total risk can be broken down into two categories

Idiosyncratic risk (also known as diversifiable risk, company-specific risk)

– the part of risk that gets washed away by opposite events occurring to
companies inside your portfolio because the events are uncorrelated

Systematic risk (also known as non-diversifiable risk, market risk)

– the part of risk that cannot be eliminated through diversification; involves
events that “systematically” affect all stocks

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Systematic vs Idiosyncratic Risk

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Foundations of CAPM

Given:

1. Investors prefer to hold well-diversified portfolios

2. There is a limit to diversification

We can eliminate idiosyncratic risk, but there will still be systematic risk
Investors require compensation only for systematic risk

⇒ To measure the systematic risk of an asset, we estimate the sensitivity of

its return to the market return

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Market Portfolio
Market portfolio is the largest portfolio we can invest in

Return on the market portfolio is denoted as r̃m

It is the market-cap weighted portfolio of all the assets

N
X
r̃m = γi r̃i ,
i=1

Portfolio weights are calculated as follows

Ei
γi = PN
i=1 Ei
with Ei = market cap of company i

It is also a well diversified portfolio

no idiosyncratic variation, only systematic (common) variation

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Characteristic Line

Characteristic line shows the relation between a securities’ return and the
market’s return
Beta β – the slope of the characteristic line – measures the systematic
risk of a security
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Measuring Systematic Risk

βi - the sensitivity of an asset return to the market return - provides a

measure of the systematic risk

r̃i,t+1 − rf,t+1 = αi + βi (r̃m,t+1 − rf,t+1 ) + i,t+1

r̃i,t+1 − rf,t+1 is the asset’s excess return

r̃m,t+1 − rf,t+1 is the market’s excess return
i,t+1 is the error

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Beta is the OLS Regression Coefficient

Mathematically it must be the case that

Cov r̃i , r̃m
βi =

V ar r̃m

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Beta is the OLS Regression Coefficient

Mathematically it must be the case that

Cov r̃i , r̃m
βi =

V ar r̃m
σi,m
= 2
σm
ρi,m σi σm
= 2
σm
σi
= ρi,m
σm

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Calculating β in Practice

β is the OLS regression coefficient

σi
βi = ρi,m
σm

In practice we do not know investors’ expectations ⇒ rely on historical

returns
σ̂i
β̂i = ρ̂i,m
σ̂m

We are implicitly assuming future returns will be similar to historical

returns
Use the Excel functions STDEV and CORREL

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Calculating β in Practice

Returns are usually calculated at a monthly, or sometimes weekly,

frequency
For monthly returns, 5 years of data are typically used
For weekly returns, 2 years of data may be used

Instead of calculating β by hand, financial analysts often retrieve it from

Bloomberg, or a similar data provider

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Slight Reformulation

r̃i,t+1 − rf,t+1 = αi + βi (r̃m,t+1 − rf,t+1 ) + i,t+1

Take expected value

E [r̃i,t+1 − rf,t+1 ] = αi + βi E [r̃m,t+1 − rf,t+1 ]

E [r̃i,t+1 − rf,t+1 ] is the asset’s risk premium

E [r̃m,t+1 − rf,t+1 ] is the market risk premium
Remember the risk premium can be interpreted as compensation for
investing in “risky” asset

The CAPM follows from αi = 0

E [r̃i,t+1 − rf,t+1 ] = βi E [r̃m,t+1 − rf,t+1 ]

E [r̃i,t+1 ] = rf,t+1 + βi E [r̃m,t+1 − rf,t+1 ]

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Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is an economic model that

relates the expected return on an asset to the expected return on the
market portfolio

Since it is a model that means it is based on assumptions

According to the model, the asset’s expected return depends on

1. The risk free rate – compensation for the time value of money
2. The risk premium, which depends on the asset’s beta and the market risk
premium

E [r̃i,t+1 ] = rf,t+1 + βi E [r̃m,t+1 − rf,t+1 ]

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Capital Asset Pricing Model (CAPM)

E [r̃i,t+1 ] = rf,t+1 + βi E [r̃m,t+1 − rf,t+1 ]

This equation holds for both portfolios as well as individual securities

(stocks, bonds, etc.)!

Recall that if we take the market portfolio to consist of only stocks (but
no other assets), we call the market risk premium the equity risk
premium
Estimates of the equity risk premium vary by source, but are usually
between 5% and 8%
Between 1926 - 2020 the equity risk premium has averaged ∼ 8.0%
annually

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Intuition Behind the CAPM

Investors dislike risk and require compensation, in the form of returns

above the risk free rate, for holding a risky asset

The CAPM says

Only the systematic component of the asset risk requires compensation
The other component of the asset risk – the idiosyncratic risk – can be
diversified away and hence does not require a risk premium

Hence, according to the CAPM the return you can expect on any asset is
determined by the sensitivity of the asset returns to the market returns

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Special Cases of CAPM

E [r̃i,t+1 ] = rf,t+1 + βi E [r̃m,t+1 − rf,t+1 ]

1. What is the beta for an asset with zero risk (=risk-free

asset)?

E [rf ,t+1 ] = rf,t+1 + βf E [r̃m,t+1 − rf,t+1 ]

|{z}
=0

2. What is the beta for the market portfolio?

E [r̃m,t+1 ] = rf,t+1 + βm E [r̃m,t+1 − rf,t+1 ]

|{z}
=1

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Outline

Introduction

Capital Asset Pricing Model

CAPM and opportunity cost of capital

Appendix: Portfolio betas

Appendix: Does CAPM work?

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CAPM and Opportunity Cost of Capital
Beta is all that matters for one firm’s cost of capital relative to another’s

Estimating the discount rate for an (all equity financed) firm or project

1. Get current risk-free interest rate for U.S. Treasury Securities

rf,today

2. Take a position on the magnitude of the historical equity risk premium

E [r̃m − rf ]

3. Estimate the firm’s βi

σ̂i
β̂i = ρ̂i,m
σ̂m
4. Calculate the firm’s opportunity cost of capital using the CAPM

E [r̃i ] = rf,today + βi E [r̃m − rf ]

| {z }
=ri∗

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Example: Opportunity Cost of Capital
Suppose you have a stock A with the beta equal to 1.8. Risk-free return is
5% and the expected risk premium on the market is 10%

What is the the expected return on the stock A?

What is the expected return on the stock A with the beta of 1.0?

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Outline

Introduction

Capital Asset Pricing Model

CAPM and opportunity cost of capital

Appendix: Portfolio betas

Appendix: Does CAPM work?

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Appendix: Illustrating CAPM
E [r̃i,t+1 ] = rf,t+1 + βi E [r̃m,t+1 − rf,t+1 ]

The relationship between expected returns and beta can be depicted

graphically as the Security Market Line (SML)

0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

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Appendix: Illustrating CAPM
Security Market Line (SML) may look like Capital Market Line (CML),
but it is plotted in an entirely different space

The SML is in the beta-return space: µi against βi

The CML is in the risk-return space: µi against σi

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Appendix: Illustrating CAPM

Suppose you are considering to invest in stock A

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Appendix: Illustrating CAPM

0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

Instead of investing in stock A, investors would prefer to lend some of

their money and put the balance in the market portfolio
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Appendix: Portfolio Betas
Example #2:

Suppose I want to have a portfolio consisting of the market portfolio (say

the S&P 500) and T-bills

What weights should I invest in each of these securities if I want

the portfolio to have a beta of 0.75?

Note that
1. Betas for T-bills and the market portfolio

βf = 0 & βm = 1

2. Portfolio weights must add up to 1

γf + γm = 1 ⇒ γf = 1 − γm

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Example: Portfolio Betas
Portfolio beta
βp = γ f β f + γ m β m
0.75 = (1 − γm ) · 0 + γm · 1
γm = 0.75

⇒ γf = 0.25

What if I want to form a portfolio with a beta of 1.2?

βp = γ f βf + γ m βm
1.2 = (1 − γm ) · 0 + γm · 1
γm = 1.2
⇒ γf = −0.2

What does a negative weight in the risk-free asset mean?

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Example: Portfolio Betas

A positive weight in the risk free asset implies that we are lending money
(i.e., we are buying a risk free bond)

A negative weight in the risk free asset implies that we are borrowing
money (i.e., we are selling a risk free bond)

γf = −0.2
if we had a total of $1 million to invest, we would invest all of this in the
market portfolio and then borrow an additional $200k and invest this in
the market portfolio as well

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Appendix: Value Weighting

Portfolio returns
N
X
rp = γi ri
i=1

Portfolio expected returns

N
X
µp = γi µi
i=1

Portfolio betas
N
X
βp = γ i βi
i=1

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Example: Value Weighting

Risk free rate 0.02

Equity risk premium 0.04

Amazon Alphabet
Price per share $790 $830
Number of shares 5 8
Estimate of beta 1.42 0.89

1. What is the expected return on each of the stocks?

2. What is the expected return on your portfolio?
3. What is your portfolio beta?
4. What is the expected return on your portfolio, based on its beta?

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Outline

Introduction

Capital Asset Pricing Model

Portfolio betas

CAPM and opportunity cost of capital

Appendix: does CAPM work?

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Appendix: Does CAPM Work?

For every complex problem there is an answer that is clear, simple, and
wrong.
– H.L. Menken

The failure of the CAPM in empirical tests implies that most applications
of the model are invalid.
– Fama and French (2004)

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Appendix: Does CAPM Work?

The CAPM rests on a number of assumptions

1. All investors are rational mean-variance optimizers

2. Markets are perfectly competitive (investors can not influence prices)
3. There are no transactions costs (e.g., commissions)
4. Investors can borrow and lend arbitrarily large amounts of capital at the
risk free rate
5. All information is simultaneously available to all investors
6. All investors have the same expectations regarding asset returns

Are all of these assumptions realistic?

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Appendix: Does CAPM Work?

Trading strategy
Investor 1 buys the bottom 10% of the NYSE stocks ranked by betas∗
...
Investor 10 buys the top 10% of the NYSE stocks ranked by betas

Start in 1931 and rebalance each year

At the end of each year investors reestimate the betas of all NYSE stocks
and reconstitute their portfolios

How did their portfolios perform as of the end of 2008?

∗
Betas are estimated using returns over the previous 60 months

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Appendix: Does CAPM Work?
Actual average risk premiums and betas from portfolios
Investor 1
E [r̃1 − rf ] = 8.0%, β = 0.49
Investor 10
E [r̃10 − rf ] = 14.3%, β = 1.53

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Appendix: Does CAPM Work?
Higher-beta portfolios generated higher average returns, just as predicted
by the CAPM
High-beta portfolios are below the SML and low-beta portfolios are above
Broad support for the CAPM

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Appendix: Does CAPM Work?
The relationship between beta and actual average return has been weaker
since the mid-1960s
Investor 10 earned a return that is only marginally above that of the
market

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Appendix: Does CAPM Work?
There is little doubt that CAPM is too simple to capture everything that
is going on in the markets

Example:

1. Small stocks tend to outperform large stocks

2. Value stocks tend to outperform growth stocks

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Appendix: So Why Are We Learning This?

Out performance by small and value stocks does not bode well for CAPM
that states only beta should matter for returns

CAPM clearly does not capture the “whole truth”

But, it is still widely used in practice

3
4
of financial managers use CAPM to calculate the cost of capital
Has the benefit of capturing two important ideas in a simple way
1. Investors require higher returns for riskier projects

2. Market risk cannot be eliminated by diversification

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Appendix: Abnormal Returns, or α

One interpretation of the CAPM is that investors require compensation

to tolerate systematic risk

As an empirical matter, some securities may offer a return in excess of

that dictated by their systematic risk

Such a security offers abnormal risk-adjusted returns or just abnormal

returns
In the CAPM equation, abnormal returns appear as an intercept

E [r̃i,t+1 − rf,t+1 ] = αi + βi E [r̃m,t+1 − rf,t+1 ]

α represents returns on a security above (or below) what its systematic

risk exposure dictates.

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