4.

CAPM
Prof. Dr. Manuel Ammann

6,143 Investments
Agenda

CAPM
Case Study
Extensions of the CAPM

2 Investments
The Capital Asset Pricing Model (CAPM)

• It is the equilibrium model that underlies all modern financial theory.

• Has been developed by Sharpe (1964), Lintner (1965), and Mossin (1966)

• Builds on the results of modern portfolio theory.

• Yields a prediction for the relationship between assets’ risk and expected returns.

• Used for the determination of assets’ expected/required returns and for the evaluation of
investments’ performances.

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Derivation of the CAPM (1/2)

• The capital market line postulates the following relation between the expected return
and the risk of an efficient portfolio (consisting of the risk-free asset and the market
portfolio):
E (rm ) − rf
E (rp ) = rf + p
m

➢ Investors get a compensation above the risk-free rate for bearing risk
➢ The higher the risk (i.e. the volatility) of the portfolio, the higher the compensation
➢ This relation between risk and return holds only for efficient portfolios; it does not
hold for inefficient portfolios or single securities
➢ Since idiosyncratic risk can be diversified away, investors get in equilibrium only a
compensation for bearing systematic risk
➢ For a single security, only its contribution to the risk of the market portfolio (i.e., the
systematic risk) is compensated

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Derivation of the CAPM (2/2)

• A security’s contribution to the risk of the market portfolio and thus its systematic risk can
be derived from its covariance with the market portfolio:
Cov (ri , rm )
Cov (ri , rm ) = im i  m =  im i
m

• We can now obtain the expected return–risk relation for an individual security by
replacing the volatility σp of the efficient portfolio in the capital market line with the
“systematic volatility” ρimσi of the security:
E (rm ) − rf
E (ri ) = rf + im i
m
ρim ∙ σi
• Substituting βi = σm yields the expected return-beta representation of the CAPM:
E (ri ) = rf +  i (E (rm ) − rf )
Slope

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Security Market Line

• The security market line (SML) illustrates

the relation between expected returns of
securities and their betas.

• Given the risk of an investment (as

measured by its beta) the SML provides
the required rate of return necessary to
compensate investors for the security’s
risk as well as the time value of money.

• Since market risk is the only risk in the

CAPM, securities’ expected excess
returns should only depend on their
betas.

Source: Bodie Z., Kane A., Marcus A. (2017): Investments

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Beta

• „Beta“ is the relevant factor for measuring a security’s: it reflects the security’s
contribution to the risk of the market portfolio relative to the market portfolio’s total risk.

• Betas can be estimated based on time-series regressions.

• Betas
• smaller than 1 are typical for companies in low-risk industries (such as utilities,
health care, food)
• close to 1 are typical for companies in medium-risk industries (such as banks,
automotives)
• larger than 1 are typical for companies in high-risk industries (technology, industrial
goods)

• Rule-of-thumb
• If earnings of an industry are volatile during the business cycle, the company has a
beta larger than 1.
• If the earnings are stable during the business cycle, the company has a beta
smaller than 1.

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Alpha

• The alpha of a security represents the

difference between the security’s
expected return as predicted by the
security market line and its realized
average return.

• Example:
• Stock has a beta of 1.2
• Risk-free rate is 6%
• Market Risk Premium is 8%
➢ Expected return is 15.6%
➢ Realized average return is 17%
➢ Alpha = 17% - 15.6% = 1.4%

Source: Bodie Z., Kane A., Marcus A. (2017): Investments

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The CAPM for Portfolios

• Consider a portfolio P consisting of n stocks. The expected return of the portfolio is:
n
E (rp ) =  w i E (ri )
i =1

• The beta of the portfolio is the weighted average of the individual stock’s betas:
n
 p =  w i i
i =1

• The CAPM also holds for entire portfolios:

n
E (rp ) =  w i (rf +  i (E (rm ) − rf )) = rf +  p (E (rm ) − rf )
i =1

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Assumptions of the CAPM

• Investors:
• Investors are rational mean-variance optimizers
• Expectations are homogeneous, i.e. all investors have the same expectations about
future returns and covariances
• Individual investors are price takers
• Single-period investment horizon

• Market Structure
• All assets are publicly traded
• Short positions are allowed
• No taxes and no transaction costs
• Investors can borrow and lend at the risk-free rate.
• Information is costless and available to all investors

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Critique of the CAPM

• In order to test the CAPM, we need to know the true market portfolio; but it is impossible
to pin down the portfolio of all risky assets:
• Cannot include nontraded assets
• Even not all tradable assets can be observed
➢ In reality, the efficiency of the observable market portfolio and the validity of the
CAPM are joint hypotheses that are almost impossible to test

• CAPM does not consider concerns of investors due to correlation of asset returns with
inflation, prices of important consumption items, or future investment opportunities.

• There exist nontraded assets (e.g. human capital or private business) that lead investors
to hold different portfolios of traded assets.

• Assumptions about market structure are hardly fulfilled; violation of these assumptions
affect prices.

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CAPM in Practice

• Most investors fail to consistently beat proxies for the market portfolio (e.g. the S&P500).
• Mutual funds do on average not outperform the market index on a risk-adjusted
basis.
• Indicates that the market index might be efficient.

• CAPM is still widely accepted:

• Without security analysis, alpha is usually assumed to be zero.
• CAPM frequently used to estimate firms’ cost of capital.

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Agenda

CAPM
Case Study
Extensions of the CAPM

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Case Study: Novartis (1/5)

• Goal: Estimation of Novartis’ cost of equity capital

• Step 1: Retrieve monthly returns for Novartis for a five-year horizon

• Step 2: Retrieve monthly returns for the market portfolio for a five-year horizon
• SPI as proxy for the market portfolio

• Step 3: Calculate the beta of Novartis with respect to the SPI

Cov (rNovartis , rSPI )

Novartis =
 SPI
2

• Step 4: Determine the expected return for Novartis

E (rNovartis ) = rf + Novartis (E (rSPI ) − rf )

• Yield on the 1-year Swiss Government zero-coupon bond as risk-free rate

• Assumption for the market risk premium: 4%

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Case Study: Novartis (2/5)

Step 1: Retrieve returns for Novartis

• Search for «Novartis» in the top left corner of Thomson Reuters Eikon.

• Go to Price & Charts > Price History

• Select monthly price data over a five-year period for Novartis, and hit the Excel icon to
download the data

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Case Study: Novartis (3/5)

Step 2: Retrieve returns for the SPI

• Search for «SPI» in the top left corner of Thomson Reuters Eikon.

• Go to Price & Charts > Price History

• Select monthly price data over a five-year period for the SPI, and hit the Excel icon to
download the data

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Case Study: Novartis (4/5)

• Step 3: The beta of Novartis is 1.196.

• Step 4:
• Retrieve the yield on the 1-year Swiss Government zero-coupon bond: Search for
«Switzerland Government Bond Zero 1 Year» in the top left corner of Thomson
Reuters Eikon.

• E rNovartis = −0.81% + 1.196 ∙ 4% = 3.97%

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Case Study: Novartis (5/5)

• Apply the Dividend Discount Model and conduct a valuation for Novartis. Now use the
estimated expected return of 3.97%.

2.91 3.02 3.06

Price = + +
(1+r)1 (1+r)2 r⋅(1+r)2

Price = 76.90 CHF

➢ The calculated intrinsic value is now much closer to the current stock price (per
04.01.2021) of 83.19 CHF.

• Reverse engineering – what g is the market implicitly assuming?

2.91 3.02 3.06
83.19= + + g = 0.32%
(1+r) 1 (1+r) 2 (r−g)⋅(1+r)2
r = 3.97%

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Limitations of the Model

• What is the appropriate risk-free rate to use (especially in times of negative interest
rates)?

• How to determine the expected risk premium of the market?

• Historical average might be too optimistic
• (Strong) variation in the required risk premium across time

• The beta estimate might be biased and thus might not reflect the actual systematic risk
of the respective security.

• Dividends are uncertain and forecasts might be biased

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Agenda

CAPM
Case Study
Extensions of the CAPM

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Non-Traded Assets

• Examples: privately held businesses and human capital.

• Market value of private businesses similar to market value of traded assets.
• Discounted value of labor income exceeds market value of traded assets.

• Non-traded assets have implications for equilibrium returns on traded assets when
considering them as part of investors’ portfolio.
• Investors want to diversify the risks of nontraded assets by means of investments in
traded assets.
• Higher demand and lower expected returns for assets that have high diversification
potential with respect to non-traded assets.
Vh
Cov (ri , rm ) + Cov (ri , rh )
• CAPM with labor income: Vm
E (ri ) = rf + (E (rm ) − rf )
Vh
 m2 + Cov (rm , rh )
Vm
where Vh is the aggregate value of human capital
Vm is the aggregate value of traded assets (market portfolio)
rh is the return on aggregate human capital

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ICAPM

• The intertemporal capital asset pricing model (ICAPM) assumes that investors optimize
a lifetime consumption/investment plan
➢ Investors continuously adapt consumption/investment decisions to current wealth
and planned retirement age.
➢ Relaxes the “single-period” assumption about investors of the CAPM.

• In a multiperiod context, there is not only uncertainty about portfolio returns but also
about future investment opportunities.
• Examples: changes in the risk-free rate or in returns’ probability distributions.
• Investors select their portfolios such that they hedge the risks of unfavorable
changes in the investment opportunity set.

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CCAPM

• Ultimately, investors are only concerned with the expected utility from their lifetime
consumption.

• The consumption capital asset pricing model (CCAPM) assumes that investors allocate
current wealth between consumption today and investment for the future such that their
expected lifetime utility is maximized.
• Investors select their portfolios such that they hedge future consumption risk.
• Investors consider assets with positive covariance with consumption growth to be
riskier and therefore demand higher expected returns for holding them.

• The expected return of a security in the CCAPM is given by:

E (ri ) = rf +  iC (E (rC ) − rf )
where C is a consumption-mimicking portfolio (the portfolio of assets with the highest
possible correlation with consumption growth).

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Liquidity

• The CAPM and in particular its assumption of homogenous expectations implies that
investors have no reason to trade because every investor will hold the market portfolio
at any time.

• In reality: investors have heterogenous expectations and thus want to trade.

• Liquidity: The ease and speed with which an asset can be sold at fair market value.
• Dimensions of liquidity: bid-ask spread, price impact, immediacy.

• Illiquidity Premium: Discount for an asset compared to its fair market value that the seller
must accept to obtain a (quick) sale.
• The lower an asset’s liquidity, the higher its illiquidity discount and the higher its
expected return.

• Liquidity across assets is correlated: when liquidity in one stock decreases, it tends to
decrease in other stocks at the same time.
➢ Liquidity has a systematic, undiversifiable component.
➢ Investors therefore demand compensation for liquidity risk.
➢ Empirically: firms with higher liquidity risk exposure have higher average returns.

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Literatur

• Bodie Z., Kane A., Marcus A. (2017): Investments (11th edition).

− Chapter 8: Index Models
− Chapter 9: The Capital Asset Pricing Model

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