CF Session 7 - CAPM and APT

Avijit Bansal
Indian Institute of Management Calcutta

January 16, 2023

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Tangency portfolio

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Sharpe Ratio

The line connecting risk-free asset and the tangency portfolio is called the
capital market line/capital asset line

Tangency portfolio has the highest Sharpe Ratio

E [Rp ] − rf
Sharpe Ratio =
σp

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Why will the tangency portfolio be equal to the
market portfolio?

Market portfolio is the portfolio of all possible equities containing them in the
proportion of their market capitalization

If each investor demands the same tangency portfolio with the highest Sharpe
Ratio, and

If every asset that is traded has to be held by someone, then M will be equal to
the value-weighted portfolio of all stocks

The combined holdings of stocks held by all investors must be equal to M

(demand equal supply)

Also known as the market portfolio

Demand of Efficient Portfolio = Supply of all the traded stocks

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Risk-return trade-off of other portfolios on CML

σp
E [Rp ] = rf + (E [Rm ] − rf )
σm

Every portfolio that can be formed using rf and Market portfolio will satisfy the
above equation

Note: The above equation is true only for efficient portfolios

How will you compute the risk-return trade-off of non-efficient portfolios?

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Correlation of portfolio on CML with market

Cov (w1 M + w2 Rf , M) Cov (w1 M, M) + Cov (w2 Rf , M)

Corr (w1 M + w2 Rf , M) = p = p
Var (w1 M) × Var (M) Var (w1 M) × Var (M)

By design Cov (Rf , M) = 0

w1 Cov (M, M) w1 Var (M)

Corr (w1 M + w2 Rf , M) = p = p
w12 Var (M)Var (M) w1 Var (M)Var (M)

Var (M)
Corr (w1 M + w2 Rf , M) = =1
Var (M)

Hence every portfolio on CML is perfectly correlated with the market

There is no escape from the market risk

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Risk-return trade-off of non-efficient portfolios

σp × ρpm
E [Rp ] = rf + (E [Rm ] − rf )
σm

For efficient portfolios (portfolios on CML), ρpm = 1

σm × σp × ρpm
E [Rp ] = rf + (E [Rm ] − rf )
σm × σm
Therefore, the expected risk of a non-efficient portfolio becomes

Cov [p, m]
E [Rp ] = rf + (E [Rm ] − rf )
Var [m]

Cov [p, m]
can also be interpreted as the coefficient of a regression, known as β
Var [m]

E [Rp ] = rf + βp (E [Rm ] − rf )

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How individual stock impacts portfolio risk?
Capital Asset Pricing Model

E [Ri ] = rf + βi (E [Rm ] − rf )

Risk of a well-diversified portfolio depends on the market risk

(systematic/undiversifiable risk)

Hence, a stock’s contribution to portfolio risk is only to the extent of that

particular stocks’s market risk

The market-risk of stock or the sensitivity of a stock’s returns to market returns

is also known as beta (β)

Cov [Ri , Rm ] σim

βi = = 2
Var [Rm ] σm
You can think of βi as the proportion of the market variance that arises due to stock
i ′ s co-movement with the market.

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Capital Asset Pricing Model: Implications

E [Ri ] = rf + βi (E [Rm ] − rf )

The true measure of the risk of a stock is measured by β and not by standard
deviation

βi > 1 ⇒ E [Ri ] > E [Rm ], stock is riskier than market

βi = 1 ⇒ E [Ri ] = E [Rm ], stock has the same risk as the market

βi = 0 ⇒ E [Ri ] = E [Rf ], the stock is not sensitive to market movement (it

does not imply that stock itself has no volatility)

βi < 0 ⇒ E [Ri ] < E [Rf ], very difficult to find such instances

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Capital Asset Pricing Model: Implications

Risk-return relationship as measured by β is linear (huge advantage)

βp = w1 β1 + · · · + wn βn

Risk of a portfolio is the weighted average of the β of its constituents

Expected return on a portfolio is E [Rp ] = rf + βp (E [Rm ] − rf )

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produced an answer to this question. Their answer is known as the capital asset pr
Security market line: Risk-return trade-off

◗ FIGU
The capi
Security market line the expe
Expected return on investment

ment is p
that each
rm security
and the m
Market portfolio

rf

Treasury bills

0 0.5 1.0 2.0

Beta

Source: Brealey et al. (2012)

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CML versus SML

Capital market line Security market line

Plots E [R] versus σ Plots E [R] versus β

Depicts only efficient portfolios Depicts all stocks and possible portfolios

Slope of the line is the highest Sharpe Ratio Slope is equal to the market risk premium

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Assumptions in CAPM
Note: All the assumptions are questionable

Treasury bills are risk-free

Investors can borrow and lend money at the same rate

All investors hold a combination of the risk-free asset and the market portfolio

People only care about the mean and standard deviation of portfolio returns

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 Security market line, in reality, is flatter

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Average risk premium, 1931–2017, %

tes
m any 16
ty 14
ual
12
ios
port- 10
turns, 8
the
6
he
olios 4
0 port- 2
n the
0
0 0.5 1.0 1.5 2.0
8.
Portfolio beta

Source: Brealey et al. (2012)

each portfolio should lie on the upward-sloping security market line in Figure 8.8. 14
CAPM to measure the skill of a fund manager

αp = Rp − E [Rp ] = Rp − (rf + βp (Rm − Rf ))

αp is the risk-adjusted returns

It is also called Jenson’s alpha

αp > 0 implies that the fund has outperformed its index on a risk-adjusted basis

Such invests will be above the security market line as their realized returns are
higher than the expected value

Investment with αp = 0 lies on SML

Investment with αp < 0 lies below SML

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Arbitrage Pricing Theory

CAPM assumes that the only source of non-diversifiable risk (systematic) is the
market risk

Real world is more complex than what CAPM assumes to be

E [Ri − rf ] = β1 (Rfactor 1 − rf ) + · · · + βk (Rfactork − rf )

Size factor - small cap stocks earn higher returns

Value factor - stocks with low price to book ratio earn higher returns

Momentum factor - winners of previous 6 to 12 months earn higher returns

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References I

Brealey, R. A., Myers, S. C., Allen, F., and Mohanty, P. (2012). Principles of corporate finance. Tata McGraw-Hill
Education.

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