From Chapter 13 of Financial Economics, 2. Copyright © 2008 by Pearson Prentice Hall. All ights reserved BIECTIVE Explain the theory behind the capital asset pricing model (CAPM) Explain how to use the CAPM to establish benchmarks for ‘measuring the Performance of investment portfolios, Explain how to infer from the CAPM the correct risk-adjusted discount rate {0 use in discounted cashflow valuation models, Explain how the CAPM has been modified and supplemented by other theories to add greater realism. CONTENTS 1 The Capital Asse ing Model in Brief 2 Determinants of the Risk Premium on th 3. Beta and Risk Premiums on Individual Securitic Using the CAPM in Portfolio Selection Valuation and Regulating Rates of Return Modifications and Alternatives to the CAPM vi Bodie, Robert C. Merton, David L. Clecton(CAPITAL MARKET EQUILIBRIUM ‘The capital asset pricing model (CAPM) isa theory about equilibrium prices in the markets for risky assets. It builds on the theory of portfolio selection developed earlier and derives the quantitative relations that must exist among expected rates of return on risky assets on the assumption that asset prices adjust to equate supply and demand. ‘The CAPM is important for two reasons. Firs, it provides a theoretical justification for the widespread practice of passive investing known as indexing. Indexing means holding diversified portfolio in which securities are held in the same relative proportions asin a broad market index such as the Standarl & Poor's 500 or the Morgan Stanley index of international stocks. Today many billions of dollars invested worldwide by pension funds, mutual funds, and other institutions are managed passively by indexing. and indexing provides a simple fea. sible benchmark against which the performance of active investment strategies are measured, Second, the CAPM provides a way of estimating expected rates of return for use in a variety of financial applications. For example, risk-adjusted expected rates of return ate needed as inputs to discounted-cash-flow valuation models for stocks. Corporate managers also use these models in making capital-budgeting decisions. The CAPM is also used to ‘establish “fait” rates of return on invested capital in regulated firms or in firms that do busi- ness on a cost-plus basis. 1 The Capital Asset Pricing Model in Brief ‘The capital asset pricing model is an equilibrium theory that is based on the theory of portfolio selection presented. The CAPM was developed inthe early 1960s." It was derived by posing the question: What would risk premiums on securities be in equilibrium if people hal the same set of forecasts of expected returns and risks and all chose their portfolios ‘optimally according to the principles of efficient diversification? ‘The fundamental idea behind the CAPM is that in equilibrium the market rewards people for bearing risk. Because people generally exhibit risk-averse behavior, the risk pre- mium for the aggregate of all risky assets must be positive to induce people to willingly hold all of the risky assets that exist in the economy. But the market does not reward people for holding inefficient portfotios—that is, for exposing themselves to risks that could be eliminated by optimal diversification behavior, premium on any individual security is, therefore. not related (othe security's “stand. but rather to its contribution o the risk ofan efficiently diversified portfolio, Every efficient portfolio can be constructed by mixing just two particular assets: the riskless asset and the optimal combination of risky assets (i.e. the tangency portfolio). T derive the CAPM, we need two assumptions: + Assumption 1: Investors agree in their forecasts of expected rates of return, standard deviations, and correlations of the risky securities, and they. therefore. optimally hold risky assets in the same relative proportions, *+ Assumption 2: Investors generally behave optimally. In equilibrium, the prices of securities adjust so that when investors are holding thei optimal portfolios. the aggregate demand for each security is equal to its supply From these two assumptions, because every investor's relative holdings of risky assets is the same, the only way the wssct market can clear is if those optimal relative proportions are the proportions in which they are valued in the marketplace. A portfolio that holds all assets in proportion to their observed market values is called the market portfolio. Wy ‘thers who independ iam F Sharpe received the 1990) Noe Prize in economics for his work om the CAPM published in 1964, feveloped the CAPM at about the same time were John Lintner ad Jan Mossi,CAPITAL MARKET EQUILIBRIUM The composition of the market portfolio reflects the supplies of existing assets evaluated at their current market prices Let us clarify what is meant by the market portfolio. In the market portfolio. the fi {ion allocated to security # equals the ratio of the market value of the ith security outstand! ing to the market value of all assets outstanding. Th plicity suppose that there are only three assets: GM stock. Toyota stock, and the risk-free asset. The total market values ‘ofeach at current prices are $66 billion of GM, $22 billion of Toyota, and $12 billion of the risk-free assel. The total market value ofall assets is $100 billion. The composition of the ‘market portfolio is, therefore, 66% GM stock. 22% Toyota stock, and 12% risk-free asset ‘The CAPM says that in equilibrium any investor's relative holdings of risky assets will be the same as in the market portfolio. Depending on their risk aversion, investors hol dif ferent mixes of risk-free and risky assets, but the relative holdings of risky assets are the same forall investors, Thus, in our simple example, all investors will hold GM and Toyota stock in the proportions of 310 1 (.e.. 66/22). Another way to state this is to say thatthe composition of therisky part of any investor's portfolio will he 75% GM stock and 25% Toyota stock Consider two investors, each with $100,000 to invest, Investor 1 has risk aversion equal to the average for all investors and, therefore, holds each asset in the same propor tions as the market portfolin—S66,000 in GM, $22,000 in Toyota stock, nd $12.000 in the risk-free asset. Investor 2 is more risk averse than the average and, therefore, chooses to invest $24,000 (iwice as much as Investor 1) in the risk-free asset and $76,000 in risky assets. Investor 2's investment in GM stock will be 0.75 X $76,000 or $$7.000, and! the investment in Toyota stock will he 0.25 % $76,000 of $19,000. Thus, both investors will hold three times as much in GM stock as in Toyota stock ‘This basic idea of the CAPM can also be explained with the help of Figure 1, which depicts the risk-reward trade-off ine facing each investor. Because the tangency portfolio ‘oF optimal combination of risky assets ha the same relative holdings of risky assets as the market portfolio, the market portfolio is located somewhere on the risk-return trude-ofT Hine. In the CAPM, the trade-off line is called the eapital market line (CML). In Figure | point M represents the market portfolio, point F is the risk-free asset, and the CML is the siraight fine connecting these two points ‘The CAPM says that in equilibrium, the CML represents the best risk-reward combi nations available to all investors. Although everyone will strive to achieve points that are above the CML, the forces of competition will move asset prices so that everyone expects toachieve points that are on the fine. ‘The CML’s formula is a The slope of the CML is. thus, the risk premium on the market portfolio divided by its standard deviation Ey) Slope of CMLThe Capital Market Line act Fin CAPITAL MARKET EQUILIBRIUM Expected Return = ‘The CAPM implies that most investors would do just as well to passively combine the risk-free asset with an index fund holding risky assets in the same proportions as inthe market portfolio as they would by actively researching securities and trying to “heat” the market, Especially diligent and competent investors do tend to earn rewards for thew eforts, but over time the competition among them reduces those rewards to the minima necessary to induce them to perform their work. The rest of us can then benelit from thee work by investing passively Another implication of the CAPM is thatthe risk premium on any individual security i Droportional only to its contribution to the risk of the market portfolio, The risk premigas dloes not depend on the security's stand-alone risk. Thus, according tothe CAPM. in equi ‘ium, investors get rewarded with a higher expected return only for bearing market risk. Thee isan irreducible or necessary risk that they must take to get their desired expected return ‘The logie here is that because all efficient risk-reward combinations can be achieved simply by mixing the market portfolio and the risk-free asset, the only risk an investor neal bear to achieve an efficient portfolio is market risk. Therefore, the market does not ewan investors for bearing any nonmarket risk ‘The market does not reward investors for choosing inefficient portfolios. Sometimes this implication of the CAPM is emphasized by saying that only the marks related risk of a security “matters.” 2 Determinants of the Risk Premium on the Market Portfolio According to the CAPM. the size ofthe risk premium of the market portfio is determs by the aggregate risk aversion of investors and the volatility of the marl induced to accept the risk of the market portfoli return. To: investors must be offered an ex;CAPITAL MARKET EQUILIBRIUM ‘guarantees returns that match those of a market index, but atthe cost of the chance to benetit, 1 market inefficiencies. The relative market capital 1 alone of a particular stock determines the propor: that a passive investor holds of that stock. Active stors, on the other hand, try to beat an index. Still, investors don’t necessarily achieve h passive investors n fact, just over half of actively cd! mutual funds beat the S&P $00 in 2005, Research has shown that passive investing accounted most of the trading volume on U.S. stock markets dur Ine early 2000s. AL the same time, the amount invested in passive finds in 2008 was less than one-filth of the amount invested in active funds. This contradiction indi ccates that even actively managed funds may take a passive approach, preferring mediocre returns to the Fisk of trying to beat the market. As passive investin ity Prices may reflect less of the information relevant their pricing. creating more opportunity for active investors to profit from market inefficiencies Seance anary 2 Adapted from rate of return that exceeds the risk-free rate of interest, ‘The greater the average degree risk aversion of the population, the higher the risk premium required. In the CAPM, the equilibrium risk premium on the market portfolio is equal to the the holders of wealth (A) A should be tho ince of the market portfolio times a weighted av ge of the degree of risk aversion of Evy)", = Ao}, a oF as an index of the degree of tisk aversion in the economy Suppose that the standard deviation of the market portfolio is 0. and the average degree of risk aversion is 2. Then the risk premium on the market portfolio is 0.08: Evy) =r, = 02 0.04) = 0.08, Thus, according to the CAPM, the market risk premium can change over time either because the var both. nce ofthe arket changes, because the degree of risk aversion changes, or Note that the CAPM explains the difference between the riskless interest rate and the expected rate of return on the market porifolio, but not their absolute levels. As discussed in previously, the absolute level of the equilibrium expected rate of return on the market portfolio is determined by factors such as the expected productivity of the capital stock and houschold intertemporal preferences for consumption, Given a particular level for the expected return on the market, the CAPM can be used to determine the riskless rate of interest. In our numerical example, if the expected return ‘on the market portfolio is 0.14 per year, then the CAPM implies thal the risk-free rate must be 0.06 per year, Substituting these values into equation 1. the CML is given by the following Formula Ey )—r f 6, = 0,06 + 0.400 where the slope, the market reward-to-risk ratio, is 0.40.CAPITAL MARKET EQUILIBRIUM What would the slope of the CMI be if the aver degree of tisk aversion increased 3 Beta and Risk Premiums on Individual Securities iy definition, equilibrium asset prices and expected returns are such that knowledgeable investors willingly hold the assets they have in their optimal portfolios. With the idea that nesiors must be compensated in terms of expected return for bearing risk, we define the risk of a security by the size of its equilibrium expected return, Thus, the risk of ‘curity A is larger than the risk of security B if in equilibrium the expected return on A exceeds ve Fa clan on B. By inspection ofthe CML in Figure I, among optimal efftenn port folios, the larger the standard deviation ofits return, the larger the equilibrium, expected iuen E(7) and, therefore, the larger the risk. Hence, the risk of an effciemt portfolio i measured by ¢: However, standard deviation of return does Greek letter B). Technically, beta describes the marginal contribution of that security's eturn to the standard deviation ofthe market portfolio’ return. The formula forthe bet security jis given by where oh denotes the covariance between the return on security j and the return on the ‘market portfolio? According t the CAPM, in equilibrium, the risk premium on any asset is equal o its imes the risk premium on the market portfolio, The equation expressing this slation io £0) = BEG) ~ 71 @ i z f Called the security market line (SML) relation, and itis depicted in Figure 2. Note that in Figure 2. we plot the securiy’s beta on the horizontal axis and is expec Folie Tea on the vertical. The slope ofthe SML isthe risk premium on the market port- folio In our example, because the market risk premium is 0.08 oF 8% per year the SAIL relation is EU) ~n, = 0.088, Beta also provides a proportional measure of the sensitivity of a security's realized Keir to the realized return on the market portfolio. Thus, if the realized retumn on the mat ker portfolio is NY greater (ess) than was expected, dhen the realized rum on security J ill tea o be 8; XN greater (ess) than was expected, Thus, securities with hish ben (ereale than 1) are called “aggressive” because their returns tend to accentuate thene ofthe Grerll market portfolio, going up more in up markets and down more in down markets Similarly, securities with low betas (less than 1) are called “efensive:” The maker portfolio, by defini ta of 1, and securities with a beta of 1 are said to have “average risk: Simca he eeresson ceficint estimator ofthe slne from the inca regression model outlined afedag neeetesson he independ varible 1) she return rm the market potalcaad eee individual security ithe dependent sana ()Security ket Line Ail sceurtes (not just i portfolios plat on {Lif they are correctly coring tthe CAPITAL MARKET EQUILIBRIUM “tl 0. "| M [ [ r r Risk Premium =0.10} ~0.20 Beta If any security hal an expected return and beta combination that was not on the SMI it would be a contradiction of the CAPM. In particular relurn/beta combination represented by point J in Fi its expected return is “too low" to support equilibr ‘market price is too high.) ‘The existence of such a situation contradicts the CAPM because it implies either that the market isnot in equilibrium or that investors do not agree on the distribution of returns oF that investors are not behaving as mean-varianee optimizers. Under the assumptions of the CAPM, investors could improve their portfolios by investing less in security J and ‘more in the other securit dem: imagin a security with an expected Because it lies below the SMI mi, (Equivalently, we can say that its es. Therefore, there is excess supply of security J and excess i for the other securities. Any portfolio that fies on the CML (.c., any portfolio formed by mixing the market Pontfolio and the riskless asset) has a beta equal to the fraction of the portfolio invested in the market portfolio. For example, the beta of a portfolio th Portfolio and 0.25 invested in the risk-free asset is 0.75. 480.75 invested in the market eS The CAPM can be used 10 decompose the total risk (03) of an individual security's ‘elum into diversiiable and undiverstiale components. As Was noted ear. the risk pre Inium of a seeurty dovsn’t depend on the security's total risk but rather on ite mart related risk. Because in equilibrium every investor holds risky assets in proportion te the tmarket weighs in the aggregate market portfolio it isthe undiveriiahle component af individual security's risk that the investor bears whereas the diversifiable component ofthe security’s risk is eliminated, For any risky security, its undiversitiabe ris is given by i? -o7, whereas the divers Hable risk ean be found as the residual by subtracting the undiversifiable risk trom the eu tisk: 07 -~(B7- Bi). For example a security with a beta of +1 would have undiversatshie “sk equa to that of the market portfolio, Because in equilibrium, in the CAPM the rik pre iium is dependent only on the undiversfiale risk. such a security would offer an expected Fisk premium equal to that ofthe market portfolio, Whi held as part of the market portfolioCAPITAL MARKET EQUILIBRIUM its diversifiable risk would have becn eliminated and therefore be of no concern. If om ‘other hand, an investor were unwise and held the security by itself, she would be sul {o both the diversfiable and undiversfiable tisk components while only being rewandel the latter source of risk. 4 Using the CAPM in Portfolio Selection fon 3, the CAPM implies that the market portfolio of risky assets eM portfolio. This means that an investor will do as well by simply following = sive portfolio selection strategy of combining a market index fund and the risk-free by following an active strategy of trying to beat the market. ‘Whether or not the CAPM applies to real-world asset prices, it nevertheless prow onale fora simple passive portfolio strategy: {Diversity your holdings of risky assets in the proportions of the market portfoli, * Mix this portfolio with the risk-free asset to achieve a desired risk-reward combi The same passive strategy can serve as a risk-adjusted be formance of active portfolio selection strategies, et us illustrate, Suppose that you have $1 million to invest. You are deciding allocate it among two risky asset classes: stocks and bonds and the risk-free sce Know that in the economy as a whole, the net relative supplies of these three asser {are 60% in stocks, 40% in bonds, and 0% in the risk-free asset. This, therefore. isthe Position of the market portfolio. I you have an average degree of risk aversion, then you will invest $600,000 im $5400.000 in bond, and nothing inthe risk-free asset. If you are mone risk averse than ‘age. you will invest some of your $1 million in the risk-free asset and the rest in ste bonds, Whatever amount you invest in stocks and bonds will be allocated in the tions 60% in stocks and 40% in bonds, Jn assessing the performance of portfolio managers on a risk-adjusted asia CAPM suggests a simple benchmark hased on the CML. It consists of comparing Gf fetum earned on the managed portfolio to the rate of return attainable by simply the market portfolio and risk-free asset in proportions that would have prodiced she volatility. chmark for measuring the The method requires one to compute the volatility of the managed port relevant period in the past—for instance. the last 10 y average rate of retum would have beer —and then to figure out N On a strategy of mixing the market port ith that same volatility. Then compare the erage rate of return to this simple benchmark portfolio’s average et portfolio actually used in measuring the performance of agers iva well-iversifed portfolio of stocks rather than the true market ps all risky assets. It turns out thatthe simple benchmark strategy has been a diflicak beat. Studies ofthe performance of managed equity mutual funds consistently fina simple strategy outperforms around two-thirds of the funds. As a result. more he and pension funds have been adopting the passive investment strategy used as the mance benchmark. This type of strategy has come to be known as indexing, Portfolio used asa proxy for the market portfolio often has the Stock market indexes such as the Standard & Poor's 500, same weights as wel ‘of risk aljuste retum see: Franco and Leah Modigliani, “Risk Performance: How to Measure It and Why.” Journal of Porgulio Meas prnaee i tielian. “Risk- Aaees CAPITAL MARKET EQUILIBRIUM Mhether or not the CAPM isa valid theory. indexing isan attractive investment strat Fey ot at least two reasons. Fist as an empirical matter, it has historically performed beter than most actively managed portfolios. Second. it costs less to implement then ae active portfolio strategy. bee: Priced securities, and the cost of transactions is typically much less ‘As ne have seen, the CML provides a convenient and challenging benchmark for me suring the perfonmance of an investor's entre portfolio of assets, However, houscholds na Pension funds often use several different portfolio managers, each of whom man ‘one does not incur the costs of research to look for mis. only sence the whole portfolio, For measuring performance of such managers, the CAPR, 18 a different benchmark—the SML As We saw in section 3, the CAPM holds that every security has a risk premium equal to is beta Gimes the risk premium on the market portfolio. The difference between the ge ae ais cli on Security oF a portfolio of securities and ils SML relation is called alpha (the Greek letter 0, It's portfolio manager can consistently produce a positive alpha, then her performance is udged (o be superior, even ifthe managed portfolio does not outperform the CRIL stand-alone investment, To understand this puzzle, consider how a fund with a positive alpha can he used by an investor in combination with the market portfolio and the risk-free asset to crear Ponfolio thal outperforms the CML. Let us illustrate with an example Assume that the risk-frve rate is 6% per year. the risk premium on the market portfolio iia Per year and the standard deviation on the market portfolio is 20% per yes Suppose the Alpha Fund isa managed mutual fund with a beta ofS, an alpha of Ise Per year, and a standard deviation of 15% Figures 3 and 4 show the relation of Alpha Fund to the SML and the CML. In both fig Ta, Point Alpha represents the Alpha Fund. In Figure 3, Alpha lies above the SML Alpha Fund's «is measured as the vertical distance between Alpha and the SML In Figure 4, Alpha lies below the CML and, therefore. is not efficient Alpha Fund ould never be held by any investor asa total portfolio because investors coult chien lower risk and/or bigher expected retuen by mixing the market portfolio and the risk-free Pa However by combining Alpha Fund with the market portolio in certain optimal prc Portions. investors ean achieve points that lie above the CML Point @ in Figure 4 corresponds to the optimal combination of Alpha Fund and the market portfolio. By mixing this portfolio with the rsk-ftee assc, investors eam cchfens fk tum combinations anywhere along the line connecting points Fand O. the Ierhea tine that lies above the CML. Thus. if yu can find a portfolio manager with a positive You can beat the market (indexing investment strutew)) 020} 2 Fund and I Security - t Line an SML has.a slope = ol cat Alpha Funds a LO tua fund vith jo 1 matic ZCAPITAL MARKET EQUILIBRIUM 0.20 Alpha Fund and the Capital 0.16 = Market Line E rie \ 3 on = ™ CML Noes Therik-ece mies 6% ee” bapa reryear. therak-pemiomon —& = the market pont 8 2 os a year. andthe standard & |e {vation onthe markt a oF Polo 20% pe oa ‘The CML ta ashe of 0 und amazed nen eee and with an expected 005010 aS 020020, ‘ate of return of 1% per year anda cof 13%. Valuation and Regu! In addition to their use in portfolio sek ash flow (DCF) v jons of firms, They are also used to establish “fair” employed in discounted Standard Deviation lating Rates of Return on, risk premiums derived ftom the CAPM are Iuation models and in capital-budgeting deci of retum on invested capital in regulated firms or in firms that do business on a cost-plus basis, In this section, we offer brief examples of each of these applications. Exchange-traded funds (ETFs) were first introduced in the United States in 1993, and have since become a popular allemative to other types of investments. Like mutual funds, ETFs offer investors shares in a fund that owns securities; however, ETFS are traded continuously on an exchange, like stocks. They also offer investors the low trading costs and tax efficieney associated with index vesting. Continuous trading allows for short-term spec ulation and protects ETFs from late trading and market ing, malpractices associated with some American ‘mutual funds. ‘The popularity of ETFS among various types of investors, from hedge funds to small traders, led to the creation of new ETFs in the United States, Europe, and Japan during the late 1990s and early 2000s, However, many ETFs were forced to close down because demand ‘was insufficient to cover costs, especially with high fees ‘charged by index providers. ETFs are also performing well in some emerging mar- kets, Since Mexico started to permit ETFs to be held in its retirement system, Barclays’ iShares Funds now have @ 15% share of all stock market trading. While there might not be room for much more than one of each type of index-linked ETF, new types of ETFs entering the market may give investors even more options. Source: Adapted from “Entirely Too Freneie?” The Economist, Jay 29,2004,EE Nn i CAPITAL MARKET EQUILIBRIUM Some widely used methods of valuing atfirm’s stock view the price of a sh Value of all expected future dividends discounted at the market capitalizat 2 Bree 0 UFH Ok wh re D, is the expected divider nd per share in period f and & is the risk-adjusted discount Tate, which is the expected + rate of return that investors require to inv fest im the stock. In ‘applying this formula, analysts often employ the CAPM i ‘compute k For example, Steadygrowth Corporation's dividends per share are expect «to grow at constant rate of 10% Per year. The expected stream of future dividends ig a wD DD, $5 $5.50 $6.05 ete een SE ‘The presen! value ofa perpetual stam of dividends growing ata const ant rate, gis - 0a ‘With Steadygrowth’s data, this implies that the price ofthe stock ig a 0" F010 One way to find & is to estimate Steadygrowth’s beta and infer Steadygrowth's risk premium from the SML relation: KE geudy = 07 + BaagrglElty) — 1) Thus. suppose that the risk-free rate is 0.03, B,., ‘market portfolio is 0.08. Then k growth rate DDM, the es 5. and the risk premium on the 0.15 per year. Substitutin, 2 this value into the constant stimated value of Steady —— = 100 0.10 Corporate financial managers need to know their firm’s cost of capital to m, {cantal-budgeting) decisions. The liem’s cos of capital isa weighted ney Se iegepbital and debt, Practitioners often use a CAPM-hasedl method sie Wwe just demonstrated for Steadygrowth Corporat‘CAPITAL MARKET EQUILIBRIUM For example, suppose that you are the financial manager of ABC Corporation and you ‘want 1o compute your firm's cost of equity capital. You compute the beta of ABC stock and find it to be 1.1. The current risk-free rate is 0.06 per year, and you assume that the market risk premium is 0.08 per year. Then according to the SML, the equilibrium expected tale of return on ABC stock is, Elan y+ BygclECty,) — 1,1 0.06 + 1.1(0.08) = 0.148, ‘Thus, 14.8% per year is ABC’s cost of equity capital, Regulation and Cost-Plus Pri Regulators may use the CAPM (o establish a “fair” rate of return on invested capital for Public utilities and other firms subject to price regulation. For example. a commission reg ulating an electric power company may have to establish a price that the company is allowed to charge its customers for electricity. The commission will do so by computing the cost of producing the electricity, including an allowance for the cost of capital ‘Similarly, in situations in which a price is negotiated by two parties based on produc- tion cost, there is often a need to decide on a fair allowance for the cost of capital. An example would be a noncompetitive (secret) contract to develop or produce military equip- ment for a government. In computing the cost of capital, a regulatory commission must compensate the providers of capital for the risk they bear by investing in the electric utility. Because the investors are able to diversify their investment portfolios. the only risk the regulators need to compensate them for is market risk, as measured by beta 6 Modifications and Alternatives to the CAPM Ascarly as the 1970s, researchers testing the empirical validity ofthe Security Market Line using the historical returns of common stocks in the United States found that it did not seem 10 fit the data well enough to explain fully the structure of expected retums on assels, Subsequent and currently ongoing research formulated and tested a variety of enriched CAPM and alternative models using data from a variety of asset markets around the world. A consensus has emerged that the original simple version of the CAPM needs to be modified + Potential explanations forthe apparent deviations from the CAPM fall into three cate gories. One such is that the CAPM actually does hold, but the “market” portfolios used in the testing were incomplete and inadequate representations of the true market portfolio. Another focuses on market imperiections not contemplated in the CAPM, such as borrow- ing costs and constraints, shortsale restrictions and costs, different tax treatments for vari ‘ous asscts, and the nontradabilty of some important assets such as human capital. These ‘elements are likely to change over time with changes in technology, institutional structures, and regulations. A third approach has heen to add greater realism to the modeling assump. tions, while maintaining the CAPM’s basic methodology. This means retaining the fundamental assumption of the CAPM that investors (or their agents) follow the principles ‘See F. Black M. Jensen, and M. Scholes “The Capital Asset Pricing Model: Some Empirical Tessin M-Sensea. ed Salis inthe Dheory of Capina Markets, New York: Pacger 1973: Tama an |. NlacBeth, “Risk, Return and Fauilibvinm: Some Empirical Tests” Joural of Poca Econonty, 8.1973, Fasnand K. French, "Mulifactr Explanations of Asset Pricing Anomalies.” Jourmal of Finance, (996,CAPITAL MARKET EQUILIBRIUM of optimal portfotio selection, and deriving the equilibrium implications of such optimizin, behavior in the presence of additional complicating factors. One such model is the ‘multifactor Intertemporal Capital Asset Pricing Model (ICAPM), in which equilibrium rish Premiums on securities in this dynamic model come from several dimensions of risks reflected not only by their relum sensitivities or heta on the market portfolio but also by their sensitivity to other systematic risks such as chan returns on assets and chan; 8 in imlerest rates and expected es in consumption good prices. In this world, securities ha Ficher set of hedging roles in addition to their place in the market portfolio, Another line of res rch has been to develop alternative theories, The most prominen! is the Arbitrage Pricing Theory (APT). According to the APT a relation similar to the Seeu rity Market Line can exist even if investors are not mean-variance optimizers, If there are enough different securities to “diversify away” all but market risk. the APT shows that an expected-return-to-beta relation will exist as a consequence of there not being any arbitray ‘opportunities. Although the specific structure of asset risks in these models differs from CAPM, the basic insights of the CAPM—that the risk premiums are related to broad sy ic risk factors that matter to large segments of the population —still hold The CAPM has three main implications + Inequilibrium, everyone's relative holdings of risky assets are the sam market portfolio, asin th * The size of the risk premium of the market portfolio is determined by the risk aversion of investors and the volatility of the retur * The risk premium on any asset is equal to its beta times the risk premium on the market portfolio, Whether or not the CAPM is strictly true, it provides a rational portfolio st * Diversify your holdings of risky assets according tothe pr portfolio, and portions of the market * Mix this portfotio with the risk-free asset to achieve a desired risk-reward combination, The CAPM is used in portfolio management primarily in two ways: * to establish a logical and convenient starting point in asset allocation and secur selection, and * Wo establish a benchmark for evaluating portfolio- management ability on a risk adjusted basis, In corporate finance, the CAPM is used to determine the appropri Tate in valuation models of the firm and in capital-by ting decisions, The CAPM is als used to establish a “fair” rate of return on invested capital for regulated firms and in cos plus pricing, Today few financial scholars consider the CAPM in its simplest form to by ‘model for fully explai ing or predicting risk premiums on risky assets. However, modified versions of the model are still a central Feature of the theory and practi The APT gives a rationale for the expected return—beta relation that relies on th dition that there be no arbitrage profit opportunities: the CAPM requites that investors he ‘mean-variance portfolio optimizers. The APT and CAPM are not incompatible: rather, the complement each otheCAPITAL MARKET EQUILIBRIUM Key Terms + capital asset pricing model + security market line + market portfolio + indexing + capital market fine + alpha + beta Answers to Quick Check Questions Quick Cheek 1 Investor 3 has a $100,000 portfolio with nothing invested in the risk-free asset, How much is invested in GM and how much in Toyota? Answer: $75,000 is invested in GM stock and $25,000 in Toyota tock, Quick Check 2 According tothe CAPM, what is a simple way for investors to form their optimal portfolios? Answer: According to the CAPM, simple way for investors to form thei optimal port= folios is to combine the market portfolio with the risk-free asset. Quick Check 3 What would the slope of the CML be ifthe average degree of risk aver- sion increased from 210 3? risk aversion increased from 2 to 3, the risk premium on the market portfolio se from 0.08 10 0.12, and the slope of the CML would inerease from 0.4 10 0.6, Quick Check 4 Suppose you are examining a stock that has « beta of 0.5. According to the CAPM, what should be is expected rate of return? Where should the stock be located in relation to the CML and the SML? Answer: Astock with a beta of 0.5 should have an expected risk premium equal to half the risk premium on the market portfolio. Ifthe market risk premium is 0.08, then the stock's ‘expected rate of return should be the risk-free rate plus 0.04. The stock would be located on the SML at a point halfway between the vertical axis and point M. It would be located on or below the CML ata latitude corresponding to its expocted rate of return of r++ 0.04, Quick Check 5 Ifthe CAPM were empirically accurate, then what should be the alpha of all portfoi Answer: According to the CAPM, all portfolios should have an alpha of zero. Quick Check 6 What would be the estimated value of Steadygrowth stock ifits beta was 2 instead of 1.5? Answer: I Steadygrowth’s beta is 2, then k = 0.19, and P, per share 50.19 ~ 0.10) = $55.56 Questions and Problems The Capital Asset Pricing Model in Brief 1. Suppose there are only three risky assets, IAM stock, IBM stock. and ICM stock. The total market equity values of these companies at current prices are $150 million for TAM, $300 million for IBM, and $1,500 million for ICM, In addition there is $50 million of riskless bonds in the market. The proportion of the riskless asset held in the aggregate market portfolio would be?6. J UF the Treasury bill ra . The riskless rate CAPITAL MARKET EQUILIBRIUM * Capital markets in Flatland exhibit rade in four securities, the stocks X. Y. and Z, and a riskless government security, Evaluated at current prices in U.S. dollars, the total market values of these assets are, respectively, $24 billion, $36 billion, $24 billion, and $16 billion a, Determine the relative proportions of each asset in the market portfolio, . Ifan investor holds risky assets in proportion to their market values and divides their aggregate portfolio of $100,000 with $30,000 invested in the riskless asset how much is invested in securities X, Y, and Z? With a riskless rate of 0.06, an equity market premium of 0.05, and a Capital Marke Line of slope 0.75, we can infer what about the risk of the market portfolio? js currently (2.04 and the expected return to the marke Portfolio over the same period is 0.12, determine the risk premium on the market Ithe standard deviation of the return on the market is 0.20, what is of the Capital Market Line? squation 9 interest is 0.06 per year, and the expected rate of return on the market portfolio is 0.15 per year 1. According to the CAPM, what is the expected rate of return of 0.10 per year? bb. IFthe standard deviation of the rate of return on the market portfolio is 0.2 is the standard deviation on the above portfoli« € Plot the CML and locate the foregoing portfolio on the same graph 4. Plot the SML and locate the Fore- going portfolio on the same graph, Given the information from the previous problem (problem 2), Estimate the value ofa stock with an expected divid dividend growth rate of ( icient way for an investor to achieve an DM per year forever, and a heta of 0.8. Iits market price is less than the value you have estimated (i.e. iil is under-priced), what is true of its expected rate of return? I the CAPM is valid, which of the following situations is possible? Explain. Consider each situation independently Portfolio Expected Return Beta A 020 14 B ( b Expected Standard Portfolio Return Deviation A 0.0 AS% k 040 Expected Standard Portfolio Return Deviation Risk five 0.10 D Market O18CAPITAL MARKET EQUILIBRIUM Expected Standard Portfolio Return Deviation Risk free 0.10 0 Market os 2406 A 020 22% Determinants of the Risk Premium on the Market Portfolio 8. Suppose the risk-free rate is 0.10 and a security with a beta of +1 has an equilibrium expected rate of return of 0.15, What is the equity market premium’? 9. Suppose the equity market premium is 4% and a security with a beta of +1.25 has an equilibrium expected rate of return of 0.10. Ifthe government wishes to issue risk-free ero-coupon bonds with aterm to maturity of one period and a face value per bond ‘0F$100,000, how much can the government expect o receive per bond? 10. Consider a portfolio exhibiting an expected retum of 0.20 in an economy in which the riskless interest rate is 0.08. the expected return to the market portfolio is 0.13, jation of the return to the market portfolio is 0.25. Assuming, Beta and Risk Premiums on Individual Securities LL. Suppose the realized rate of return on the market portfolio is one percentage point ‘greater than its expected return, Then a security with a beta of +2 would have a alized rate of return that compares how with its expected return? 12, Security s beta canbe written as: p, = Zt where gis the covariance between the return on security / and the return on the market portfolio, m. In turn the covariance is the product of the correlation and the standard deviations OF: Oy = Pye What risk characteristics do securities with betas equal to +1 possess? Those with betas, ‘equal to zer0? 13. I the return on the market portfolio is 0.12 and the riskless rate is 0.07, use the CAPM. {o determine if the following stocks are mispriced: Stock Expected Return Beta M ois 08 M&M 0.135 12 14, The Suzuki Motor Company is contemplating issuing stock to finance investment in prevlucing a new sports-utility vehicle, the Seppuks. Financial analysts within Suzuki forecast that this investment will have precisely the same risk as the market portfolio, where the annual return to the market portfolio is expected to be 0.15 and the current risk-free interes rate is 0.05. The analysts further believe thatthe expected return to the Seppuku project wll be 0.20 annually. Derive the maximal beta value that would duce Suzuki to issue the stock.CAPITAL MARKET EQUILIBRIUM Petersburg Associates, a fi of financial analysts specializing in Russian financial inarkets,fonceasts thatthe tock ofthe Siberian Drilling Company will he wont 1.000 rubles per share one year from today. I'he riskless interest rate on Reccton government securities is 0.10 and the expected return to the market portfolie is 0.18, determine how much you would pay fora share of Siberian Drilling stock, taday gt a. the beta of Siberian Drilling is 3 b. the beta of Siberian Drilling is 0.5: Using the CAPM in Portfolio Selection 16. Suppose that the stock ofthe new cologne manufacturer, Eau de Redman, Ine. has been forecast fo have a return with standard deviation 0.30 and a correlation with the market portfolio of 0.9. If the standard deviation ofthe yield on the marker x toot aftermine the relive holdings of the market portfolio and Eau de Reslman stock co form a portfolio with a beta of 1.8, 17. The current price ofa share of stock in the Down Under Clothing C ‘ompany of Ausiralia is A8S0 and its expected yield over the year is 0.14, The market ek the sock ee Atstaia i 0.08 and the rskless interest rate 0.06, What would happen to the stock's current price its expected future payout remains constant while te Govariance ofits rate of return with the market portfolio alls hy 50 percent? 18 Suppose that you believe tha the price ofa share of IBM stock wyear trom tay wil beedual othe sum ofthe price of a share of General Motors stock plus the price of stare of Exxon-Mobil and further you helieve that the price of stare of IBM act in arn cat wil be $100 whereas the price of «share of General Motors today is $30. Ir the anni yield on 91-day Till (le riskless rate you use) is 0.05, the expected yield tn the market s 0.18 the variance of the market portfolios Ian the Bete of IBN what price would you be willing to pay for one share of Exxon-Mobil stock wanes » Challenge Problem: During the most recent 5-y period. the Pizzaro mutual fund Garmed an average annualized rate of return of 0.15 and hac an annualized standin! deviation of 0.30. The average risk-free rate was 0,05 per year The ave wwe rate of seat in the market index over that same period was 0.10 per yeas and the standard deviation was 0.20. How well di Pizzaro perform on atisk-aljusted base? Adiust therrisk to be equal to that of the market portfolio by building a portfolie at Phas and the riskless asset withthe same level of risk as the market portfolia 20. ‘There are only two risky assets in the ecomomy: stocks and real ota Their relative supplies are 50% stocks and 50% realestate, thus, the market portfolio will he hal Socks and haf weal estate, The standard deviations are 0.20 for stocks, 0.20 for re Fant the correlation between them is zero. The market portola's expected turn is 0.14. The riskless rate is 0.08 per year & According to the CAPM what must be the equilibrium risk premium on the market Portfolio. on stocks, and on real estate? bs Draw the Capital Market Line. What sits slope? Draw the SML. What sits formule 21. Challenge Problem: C idler a market with only the following three risky assets Expected Return Risk % Covariance with % per month o market ci, Asset | 203 2 in Asset 2 L9. 0.90 Asset 3 149 1 062 Market Portfolio 092 nr ete | ge(CAPITAL MARKET EQUILIBRIUM Consider the market portfolio comprised of 4% invested in Asset 1, 76% invested in Asset 2, and 207 invested in Asset 3. What is the expected return of this portfol ‘What are the betas of the three risky assets? Suppose the riskless rate of interest is 0.8% (8/10ths of one percent pet month). Are these three securities priced correctly? What isthe beta of the market portfolio calculated as a weighted average of the betas ‘ofits components? Valuation and Regulating Rates of Return 22, Suppose a company’s current dividend of $1.50 per share is expected to grow at a ‘constant 0,085 rate into the indefinite future. In capital markets the market risk premium is 0.08 and the risk-free rate is 0.02. I the stable beta of the company’s ‘tock is 0.8, what is the estimated current stock price? 23, Consider the results of the previous problem (problem 22). What will a 25 percent increase in the covariance between the returns on the company’s stock and the market Portfolio do to the equity market capitalization rate forthe company? By how much will the current stock price change’) 24, The Clotted Blood Corporation, a home health supply company serving hemophiliacs considering purchasing a new delivery van that will increase the radius of its service For an intial outlay of $21,250 the van is estimated to produce the following ineremental net after-tax cash flows: Time period ACF 1 85,000 2 $6.00 3 $7,000 4 5 $6,000 $5,000 In capital markets the market risk premium is 0.10 and the risk-free rate is 0.04. the stable beta of the company’s S the net present value of the investment using the estimated market capitalization rate? 25. Consider the results of the previous problem (problem 24). How will a sof one increase inthe expected return on the market portfolio impact the net present value of the investme la Sooo Suggested Readings Bodie, Z...A. Kane, and A. Marcus. vestments. 7th Ed. Boston: Irwin/McGraw-Hill, 2008. Lintner, J.~“The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets." Review of Economics and Statistics 47, February 1965, Merton, R. C. “An Intertemporal Capital Asset Pricing Model.” Econometrica 41. September 1973. "A Reexamination of the Capital Asset Pricing Mod.” Studies in Risk and Return. Eds, ‘slr and 1. Friend, Cambridge: Ballinger, 1977. 4. “Equilibrium in a Capital Asset Market." Econometrica 35, October 1966, A.“Athitrage Theory of Capital Asset Pricing.” Journal of Economie Theory 13, December 1976, Sharpe, W. “Capital Asset Prices: A Theory of Market Equilibrium.” Jounal of Finance 19, September 1964,