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Chapter
7 CAPM
Bodie, Kane, and Marcus

Essentials of Investments
12th Edition
The Capital Asset Pricing Model
• Hypothetical Equilibrium
• All investors choose to hold market portfolio
• Market portfolio is on efficient frontier, optimal
risky portfolio
• Risk premium on market portfolio is proportional to
variance of market portfolio and investor’s risk
aversion
Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 2
• No matter how much you diversify your investments,
some level of risk will always exist.
• Investors naturally seek a rate of return that
compensates for that risk.
• The capital asset pricing model (CAPM) helps to
calculate how much return on investment an investor
should expect, given the investment risk.
• The CAPM developed in the early 1960s by William
Sharpe, Jack Treynor, John Lintner and Jan Mossin.
• CAPM shows that the expected return on a security is
equal to the risk-free return plus a risk premium, which is
based on the beta of that security.
E (rD ) = rf + b D [ E (rM ) - rf ]
• E(rD) = Expected return on a security
• rf = Risk-free rate
• βD = Beta of the security
• E(rM) = Expected return of the market
What is Beta?
• Beta (β) is a measure of systematic risk (volatility) of a security compared to
the market as a whole (usually the S&P 500).
• A beta value that is less than 1.0 means that the security is theoretically less
volatile than the market (Defensive stock). For example, utility stocks often
have low betas because they tend to move more slowly than market
averages.
• Stocks with betas higher than 1.0 can be interpreted as more volatile than
the market (Aaggressive stock). For example, Technology stocks and small-
cap stocks tend to have higher betas than the market benchmark.
• Including Defensive stock in a portfolio makes it less risky than the same
portfolio without the stock. On the other hand, adding the Aggressive stock
to a portfolio will increase the portfolio’s risk, but may also increase its
expected return.
Table 7.1 The Capital Asset Pricing Model: Assumptions
• According to CAPM, the Risk premium on

individual assets:
• Proportional to risk premium on market portfolio
• Proportional to beta coefficient of security on
market portfolio
7.1 The Capital Asset Pricing Model
• Expected Returns on Individual Securities

• Expected return-beta relationship
• Implication of CAPM that security risk premiums
(expected excess returns) will be proportional to beta
𝐸(𝑟! ) = 𝑟" + 𝛽! [𝐸(𝑟# ) − 𝑟" ]
[𝐸(𝑟! ) − 𝑟" ] is called market risk premium
• The Security Market Line (SML)
• The security market line (SML) is a visual
representation of the capital asset pricing model
(CAPM).
• Represents expected return-beta relationship of
CAPM.
• Graphs individual asset risk premiums (Expected
return) as a function of asset risk (systematic, non-
diversifiable risk).
Figure 7.2 The SML and a Positive-Alpha Stock
• Alpha (𝛼 ) is the Abnormal rate of return on security in

excess of that predicted by equilibrium model (CAPM)
• It is the difference between the fair (on the line) and the
actual expected rate of return on a stock is the alpha,
denoted α.
• Applications of CAPM
• Use SML as benchmark for fair return on risky asset:
ü fairly priced shares plot exactly on the SML.
ü Underpriced stocks plot above the SML (their expected returns are
greater than predicted by the CAPM).
• Overpriced stocks plot below the SML (their expected returns are
lower than predicted by the CAPM).
• SML provides “hurdle rate” for internal projects :
ü The CAPM is also useful in capital budgeting decisions. When a

firm considering a new project, the SML provides the required
return demanded of project.
7.2 CAPM and Index Models
• Below is for self study:
• Index Model, Realized Returns, Mean-Beta Equation
• 𝑟!" − 𝑟#" = 𝛼! + 𝛽! 𝑟$" − 𝑟#" + 𝑒!"
• 𝑟-. : HPR, i: Asset, t: Period
• 𝛼- : Intercept of security characteristic line
• 𝛽- : Slope of security characteristic line
• 𝑟! : Index return
• 𝑒-. : Firm-specific effects
• The index model is estimated by applying regression analysis
to excess rates of return. The slope of the regression curve is
the beta of an asset, whereas the intercept is the asset’s alpha
during the sample period. The regression line is also called the
security characteristic line.
• Estimating Index Model

• 𝑅%" = α% + β% 𝑅$" + 𝑒%"
𝑅% = 𝑟% − 𝑟# , excess return
Residual = Actual return − Predicted return for
Google
𝑒%" = 𝑅%" − (α% + β% 𝑅$" )
7.2 CAPM and Index Models: SCL
• Security Characteristic Line (SCL)
• Plot of security’s expected excess return over risk-

free rate as function of excess return on market.
• The security's plots reveal how the security

performed relative to the market in general.
• There are two ways to determine beta:
1) Use the formula for beta, which is calculated as

the covariance between the return (ra) of the stock and the return
(rb) of the index divided by the variance of the index (over a period
of three years).
2) Perform a linear regression, with the dependent variable

performance of Apple stock over the last three years as an
explanatory variable and the performance of the index over the
same period.
7.3 CAPM and the Real World
• CAPM is false based on validity of its
assumptions.
• Useful predictor of expected returns
• Untestable as a theory
• However, Principles still valid:
• Investors should diversify
• Systematic risk is the risk that matters
• Well-diversified risky portfolio can be suitable for
wide range of investors
CML VS SML
• Portfolios that fall on the capital market line (CML),
optimize the risk/return relationship, thereby maximizing
performance. While the SML represents the market’s risk
and return at a given time, and shows the expected
returns of individual assets.
• CML use SD (standard deviation) as the risk measure.
SML, on the other hand, uses systematic risk.
• CML shows the risk and reward tradeoff of a portfolio.
SML, in contrast, shows the risk and reward tradeoff of
security.
• The slope of CML represents the sharp ratio. The slope of
SML represents Beta.
Chapter
10 Bond Prices and Yield
Bodie, Kane, and Marcus

Essentials of Investments
12th Edition
What is bond?
Ø Bond is a financial asset, issued and sold by

companies or governments in order to raise money
to finance their activities.
ü The issuer (borrower) of the bond could be a

company or a government.
ü The holder (buyer) of the bond could be individual

investors or institutional investors.
What is bond?
ü So, a bond is a debt instrument, under which the
issuer owes the holders a debt and is obliged to pay
them interest (coupon) and to repay the principal
(face value) at a later date, called the maturity date.
üBy buying a bond (as an investor), you're giving the

issuer (company or government) a loan, and they
agree to pay you back the face value of the loan on a
specific date, and to pay you periodic interest
payments along the way, usually twice a year.
10.1 Bond Characteristics
• Bond
• Security that obligates issuer to make payments to
holder over time
• Face Value ≡ Par Value
• Payment to bondholder at maturity of bond
• Coupon Rate
• Bond’s annual interest payment per dollar of par
value
• Zero-Coupon Bond
• Pays no coupons, sells at discount, pays par
value at maturity
Figure 10.1 Prices/Yields of U.S. Treasury Bonds
ü The highlighted bond matures on November 15, 2025.

ü Its coupon rate is 2.250%. Thus, the coupon payment is $ 22.5 (coupon
rate * Par Value)
ü Par value typically is $1,000.
ü The bid and ask prices are quoted as a percentage of par value.
ü Therefore, the asking price in dollars is equal to $1030.4 (Ask/100* Par
Value)
Source: Wall Street Journal Online, November 15, 2019
Figure 10.2 Listing of Corporate Bonds
ü The above table is a sample of listings for a few actively traded corporate bonds.
ü Although some bonds trade electronically on the NYSE Bonds platform, most
bonds still trade on a traditional over-the-counter market in a network of bond
dealers linked by a computer quotation system.
ü The “rating” column is the estimation of bond safety given by the three major bond-
rating agencies—Moody’s, Standard & Poor’s, and Fitch. Bonds with gradations of
A ratings are safer than those with B ratings or below.
10.2 Bond Pricing
Ø In Finance, we define the value of any financial assets as Fair Value
or Intrinsic Value.
Ø The Fair Value or Intrinsic Value is the Present Value of all Future
Cash Flows discounted at the appropriate required rate of return.
v Cash flows provided by bonds & debentures:
1) Coupons – periodic cash flows on the bond/debenture, determined

by the coupon rate.
2) Face Value – Par value or maturity value, to be repaid upon

maturity of the bond/ debenture.
Ø Bond value = Present value of coupons + Present par value
10.2 Bond Pricing
• Bond value = Present value of coupons + Present
par value
T
Coupon Par Value
Bond Value = å
t =1 (1 + r ) t
+
(1 + r ) T
• T = Maturity date
• r = discount rate
• Thus, the bond value\ price formula is:
é1 - (1 + RB ) -n ù Face Value
VB = Couponê ú+
ë RB û (1 + RB ) n
Example 1: ABC Bond
!"#$%&%' Maturity Date !"#$%&%'
()*")+$,'&-&&&
Issuer
!"#$%&%%
()*+",-$.,/01/2$
()*")+$,'&-&&&
34#"4#,+14/$!5
!"#$%&%.
Par/ Face/ ()*")+$,'&-&&&
67&&8&&& Redemption Value
!"#$%&%/
()*")+$,'&-&&&
!"#$%&%0
349"4/$:$7&;$<,1=$ ()*")+$,'&-&&&
!//9,>>? !"#$%&%0
Coupon rate 1234$526*4$,'&&-&&&
9
Bond/ Debenture Formula
Coupon Coupon Coupon Coupon Coupon FV
PV = + + + + +
(1+ Rb ) (1+ Rb ) (1+ Rb ) (1+ Rb ) (1+ Rb ) (1+ Rb )5
1 2 3 4 5
0 1 2 3 4 5
PV of Ord. Annuity 10K 10K 10K 10K 10K
+ PV of Lump Sum + 100K
The shortcut for the above calculations is:
é1 - (1 + RB ) ù Face Value
-n
VB = Couponê ú+
ë RB û (1 + RB ) n
10
Example 1: Solving for the ABC Bond
The discount rate that we use is also the market rate, or yield.
Often, it is referred to as the Yield to Maturity (YTM). If the
YTM of our ABC bond is 8% p.a., what is the price of the
bond?
é1 - (1.08) -5 ù 100000
VB = 10000ê ú+ 5
ë 0.08 û (1.08)
VB = $107,985.42
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10.2 Relationship: Yields and Prices
• There is an INVERSE relationship between
yields and the prices of bonds.
üWhen YTM (r) increases, prices (PV) decrease.
üWhen YTM (r) decreases, prices (PV) increase.
• Interest rate fluctuations are primary source of

bond market risk.
• Bonds with longer maturities more sensitive to
fluctuations in interest rate.
Figure 10.3 Inverse Relationship between Bond Prices and Yields
Table 10.2 Bond Prices at Different Interest Rates
Example 2: Par, Premium, Discount
Ø Assume you want to buy a 3-year bond with $1000 par value, coupon paid
annually at 10%.
Ø A) what is the price of the bond if the YTM is 10%?
If CR = RB, 10% = 10% Then: PV = FV, $1000 = 1000

Bond is selling at PAR
A) what is the price of the bond if the YTM is 8%?
If CR > RB, 10% > 8% Then: PV > FV, $1052 > 1000
Bond is selling at PREMIUM
A) what is the price of the bond if the YTM is 12%?
If CR < RB, 10% < 12% Then: PV < FV, $952 < 1000
Bond is selling at DISCOUNT
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10.2 Bond Pricing between Coupon Dates
• Bond Pricing between Coupon Dates:
üIf a bond is purchased between coupon payments, the
buyer must pay the seller for accrued interest, the
prorated share of the upcoming semiannual coupon.
üFor example, if 30 days have passed since the last
coupon payment, and there are 182 days in the
semiannual coupon period, the seller is entitled to a
payment of accrued interest of 30/182 of the semiannual
coupon.
üThe price of the bond would equal the stated price
(sometimes called the flat price) plus the accrued interest.
• Invoice price = Flat price + Accrued interest
10.1 Bond Characteristics
• Accrued interest and quoted bond prices
• Quoted prices do not include interest accruing between
payment dates
Annual coupon payment Days since last coupon payment
Accrued Interest (A.I.) = ´
2 Days separating coupon payments
Example: A bond (par value = $1,000) makes semi-annual payments with a coupon
rate of 6%. If 45 days have passed since the last coupon payment, what is the
accrued interest?
Coupon payment= coupon rate * Par Value = (0.06/2)*1000 = $30
45
𝐴. 𝐼. = $30× = $7.42
182
10.4 Bond Prices Over Time
• Zero-Coupon Bonds
• Carries no coupons
• Provides all return in form of price appreciation
• Since the only cash flow to be received by the holder
of a zero coupon bond is the face value of the bond, at
maturity, the value of a zero coupon is simply the
present value of a single cash flow.
• Value= FV/(1+r)^n
• FV = the face value of the bond
• r = the yield or required rate of return on the bond
• n = the number of periods before the bond matures
Example:
• What is the value of a zero-coupon bond
with a face value of $1000 that will mature
in 5 years and that has a required rate of
return of 6% per annum?
• Value= FV/(1+r)^n
• =1000/(1.06)^5 = 747.26
10.3 Bond Yields
• Yield to Maturity
• The a verage rate of return (RoR) if the bond is
held to maturity.
• Current Yield
• Annual coupon divided by bond price
• Premium Bonds
• Bonds selling above par value
• Discount Bonds
• Bonds selling below par value
10.4 Bond Prices Over Time
• Yield to Maturity versus Holding Period Return
• Yield to maturity • Holding Period

(YTM) measures Return (HPR) is the
average rate of rate over particular
return (RoR) if the investment period
bond is held to
maturity
10.5 Default Risk and Bond Pricing
• The risk of the issuer (Credit Rating) affects the

bond price.
üInvestment grade bond
• Rated BBB and above by S&P or Baa and
above by Moody’s
üSpeculative grade or junk bond
• Rated BB or lower by S&P, Ba or lower by
Moody’s, or unrated
Figure 10.8 Bond Rating Classes
Figure 10.10 Yield Spreads among Corporate Bonds
Ø Aaa-rated bonds provide less yield (return) compared to BBaa-rated bonds

because they are less risky.
10.5 Bond Indentures
ØIndenture
• A bond is issued with an indenture, which is the contract between

the issuer and the bondholder.
• Part of the indenture is a set of restrictions that protect the rights
of the bondholders.
• Subordination clause
• Restrictions on additional borrowing stipulating senior

bondholders paid first in event of bankruptcy
• Collateral
• Specific asset pledged against possible default
• Debenture
• Bond not backed by specific collateral
10.5 Credit Default Swaps (CDS)
• Credit Default Swaps (CDS)
• Insurance policy on default risk of corporate bond or loan.
• For example, if the annual premium on a five-year bond is 3%,
this means that CDS buyer would pay the seller an annual
“insurance premium” of $3 for each $100 of bond principal. This
gives the buyer protection against loss of bond value in the event
of a default
• Designed to allow lenders to buy protection against losses
on large loans

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Chapter

Bodie, Kane, and Marcus

• According to CAPM, the Risk premium on

• Expected Returns on Individual Securities

𝐸(𝑟! ) = 𝑟" + 𝛽! [𝐸(𝑟# ) − 𝑟" ]

[𝐸(𝑟! ) − 𝑟" ] is called market risk premium

• Alpha (𝛼 ) is the Abnormal rate of return on security in

• Use SML as benchmark for fair return on risky asset:

ü fairly priced shares plot exactly on the SML.

ü The CAPM is also useful in capital budgeting decisions. When a

• Estimating Index Model

• Security Characteristic Line (SCL)

• Plot of security’s expected excess return over risk-

• The security's plots reveal how the security

1) Use the formula for beta, which is calculated as

2) Perform a linear regression, with the dependent variable

10 Bond Prices and Yield

Bodie, Kane, and Marcus

Ø Bond is a financial asset, issued and sold by

ü The issuer (borrower) of the bond could be a

ü The holder (buyer) of the bond could be individual

üBy buying a bond (as an investor), you're giving the

ü The highlighted bond matures on November 15, 2025.

v Cash flows provided by bonds & debentures:

1) Coupons – periodic cash flows on the bond/debenture, determined

2) Face Value – Par value or maturity value, to be repaid upon

+ PV of Lump Sum + 100K

The shortcut for the above calculations is:

• Interest rate fluctuations are primary source of

If CR = RB, 10% = 10% Then: PV = FV, $1000 = 1000

Coupon payment= coupon rate * Par Value = (0.06/2)*1000 = $30

• Yield to maturity • Holding Period

• The risk of the issuer (Credit Rating) affects the

Ø Aaa-rated bonds provide less yield (return) compared to BBaa-rated bonds

• A bond is issued with an indenture, which is the contract between

• Restrictions on additional borrowing stipulating senior

• Bond not backed by specific collateral

• For example, if the annual premium on a five-year bond is 3%,

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