The CAPM and APT

Departament of finance and banking

Yurii V Havryliuk
3rd year student of the Odesa national economic
university
Case 1. Apple

The CAPM and APT Slide 2

CAPM: introduction

The CAPM implies that the expected return on the

its asset is determined from its beta
Beta (βi) is the regression slope coefficient when
the return on the ith asset is regressed on the
return on the market

The CAPM and APT Slide 3

The Capital Asset Pricing Model
Implications of M as the Market Portfolio
§ Efficient portfolios are combinations of the market portfolio and T-Bills
§ Expected returns of efficient portfolios satisfy:

§ This yields the required rate of return or cost of capital for efficient
portfolios!
§ Trade-off between risk and expected return
§ Multiplier is the ratio of portfolio risk to market risk
§ What about other (non-efficient) portfolios?

The CAPM and APT Slide 4

The Capital Asset Pricing Model
Implications of M as the Market Portfolio
§ For any asset, define its market beta as:

§ Then the Sharpe-Lintner CAPM implies that:

§ Risk/reward relation is linear!

§ Beta is the correct measure of risk, not sigma (except for efficient
portfolios); measures sensitivity of stock to market movements

The CAPM and APT Slide 5

The Capital Asset Pricing Model
The Security Market Line

§ Implications:

The CAPM and APT Slide 6

The Capital Asset Pricing Model
What About Arbitrary Portfolios of Stocks?

§ Therefore, for any arbitrary portfolio of stocks:

The CAPM and APT Slide 7

The Capital Asset Pricing Model
We Now Have An Expression for the:
§ Required rate of return
§ Opportunity cost of capital
§ Risk-adjusted discount rate

§ Risk adjustment involves the product of beta and market risk premium
§ Where does E[Rm] and Rf come from?

The CAPM and APT Slide 8

Beta (𝜷) calculation

Main formula:
𝒄𝒐𝒗 𝑹𝒑, 𝑹𝒎
𝜷=
𝑽𝒂𝒓(𝑹𝒎)

𝑐𝑜𝑣 𝑅# , 𝑅$
𝑐𝑜𝑟 𝑅# , 𝑅$ =
𝜎 𝑅% ⋅ 𝜎(𝑅$ )
Hence,
𝝈(𝑹𝒊 )
𝜷 = 𝒄𝒐𝒓 𝑹𝒑, 𝑹𝒎 ⋅
𝝈(𝑹𝒎)

The CAPM and APT Slide 9

Risk measurement

𝐑𝐢𝐬𝐤 = 𝑉𝑎𝑟 𝑅# =
= Systematic Risk + Idiasyncratic Risk = Systematic 𝛽2 ⋅ Var[𝑅𝑚 ]
= 𝛽$ ⋅ Var[𝑅% ]+Var 𝜖 $ = Risk
Idiosyncratic Var 𝜖 2
&'( ! )",)#
= Var[𝑅# ] ⋅ Var 𝑅% + Var errors = Risk
+,- )"

= Var 𝑅# ⋅ 𝑐𝑜𝑟 $ 𝑅% , 𝑅# + Var errors 𝑆𝑆𝑇 = 𝑆𝑆𝑅 + 𝑆𝑆𝐸

𝑉𝑎𝑟 𝑅# =Var 𝑅# ⋅ 𝑐𝑜𝑟 $ 𝑅% , 𝑅# + Var errors

𝑉𝑎𝑟 𝑅# 1 − 𝑐𝑜𝑟 $ 𝑅% , 𝑅# =Var errors

Idiosyncratic Risk = 𝑉𝑎𝑟 𝑅# 1 − 𝑐𝑜𝑟 $ 𝑅% , 𝑅#

The CAPM and APT Slide 10

The Capital Asset Pricing Model
Example:
Using monthly returns from 1990 – 2001, you estimate that Microsoft’s
beta is 1.49 (std err = 0.18) and Gillette’s beta is 0.81 (std err = 0.14).
If these estimates are a reliable guide going forward, what expected
rate of return should you require for holding each stock?

The CAPM and APT Slide 11

The Capital Asset Pricing Model
Security Market Line

25%

20%
Expected Return

15%

10% b = 1, Market Portfolio

5%

0%
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2
Beta

The CAPM and APT Slide 12

The Capital Asset Pricing Model
The Security Market Line Can Be Used To Measure Performance:
§ Suppose three mutual funds have the same average return of 15%
§ Suppose all three funds have the same volatility of 20%
§ Are all three managers equally talented?
§ Are all three funds equally attractive?
25%

20%

A B
Expected Return

15%
C
10% b = 1, Market Portfolio

5%

0%
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2
Beta

The CAPM and APT Slide 13

The Capital Asset Pricing Model
Example:
Hedge fund XYZ had an average annualized return of 12.54% and a
return standard deviation of 5.50% from January 1985 to December
2002, and its estimated beta during this period was -0.028. Did the
manager exhibit positive performance ability according to the CAPM?
If so, what was the manager’s alpha?

The CAPM and APT Slide 14

The Capital Asset Pricing Model
Example (cont):
Cumulative Return of XYZ and S&P 500

16

14

12

10
Cumulative Return

0
85

88

91

97

00

2
8

0
n-

n-

n-

n-

n-
n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-
Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja
Month

XYZ S&P 500

The CAPM and APT Slide 15

The Arbitrage Pricing Theory
What If There Are Multiple Sources of Systematic Risk?
§ Let returns following a multi-factor linear model:

§ Then the APT implies the following relation:

§ Cost of capital depends on K sources of systematic risk

The CAPM and APT Slide 16

The Arbitrage Pricing Theory
Strengths of the APT
§ Derivation does not require market equilibrium (only no-arbitrage)
§ Allows for multiple sources of systematic risk, which makes sense

Weaknesses of the APT

§ No theory for what the factors should be
§ Assumption of linearity is quite restrictive

The CAPM and APT Slide 17

Implementing the CAPM
Parameter Estimation:
§ Security market line must be estimated
§ One unknown parameter: b
§ Given return history, b can be estimated by linear regression:

The CAPM and APT Slide 18

Implementing the CAPM 15.401

Lectures 15–17: The CAPM and APT © 2007–2008 by Andrew W. Lo Slide 19

Does It Work?
Biogen vs. VWRETD

40%

30%
y = 1.4242x - 0.0016
R2 = 0.3336 20%

10%

0%
-20.0% -15.0% -10.0% -5.0% 0.0% 5.0% 10.0% 15.0%
-10%

-20%

-30%

-40%

The CAPM and APT Slide 20

Does It Work? 15.401

NASDAQ vs. VWRETD

20%

15%

10%

5%

0%
-20% -15% -10% -5% 0% 5% 10% 15% 20%
-5%

-10%

-15%

-20%

The CAPM and APT Slide 21

Does It Work?
Market-Cap Portfolios:
Over the past 40 years, the smallest firms (1st decile) had an average
monthly return of 1.33% and a beta of 1.40. The largest firms (10th
decile) had an average return of 0.90% and a beta of 0.94. During the
same time period, the Tbill rate averaged 0.47% and the market risk
premium was 0.49%. Are the returns consistent with the CAPM?

The CAPM and APT Slide 22

Does It Work?

Size-Sorted Portfolios, 1960 – 2021

1.40

1.30
Average Monthly Returns

1.20

1.10

1.00

0.90

0.80

0.70

0.60
0.70 0.90 1.10 1.30 1.50 1.70
Beta

The CAPM and APT Slide 23

Does It Work?

Beta-Sorted Portfolios, 1960 – 2021

18%

16%
Average Annual Returns

14%

12%

10%

8%

6%

4%
0.50 0.70 0.90 1.10 1.30 1.50 1.70
Beta

The CAPM and APT Slide 24

Does It Work?

Beta-Sorted Portfolios, 1926 – 2021

16.0

14.0

12.0

10.0

8.0

6.0

4.0
Low 2 3 4 5 6 7 8 9 High
F irm s so rted b y EST IM AT ED BETA

The CAPM and APT Slide 25

Does It Work?

Volatility-Sorted Portfolios, 1926 – 2021

16.0

14.0

12.0

10.0

8.0

6.0

4.0
Low 2 3 4 5 6 7 8 9 High
Firms sorted by ESTIMATED VOLATILITY

The CAPM and APT Slide 26

Recent Research
Other Factors Seem To Matter
§ Book/Market (Fama and French, 1992)
§ Liquidity (Chordia, Roll, and Subrahmanyam, 2000)
§ Trading Volume (Lo and Wang, 2006)

But CAPM Still Provides Useful Framework For Applications

§ Graham and Harvey (2000): 74% of firms use the CAPM to estimate
the cost of capital
§ Asset management industry uses CAPM for performance attribution
§ Pension plan sponsors use CAPM for risk-budgeting and asset
allocation

The CAPM and APT Slide 27

Key Points
§ Tangency portfolio is the market portfolio
§ This yields the capital market line (efficient portfolios)

§ The CAPM generalizes this relationship for any security or portfolio:

§ The security market line yields a measure of risk: beta

§ This provides a method for estimating a firm’s cost of capital
§ The CAPM also provides a method for evaluating portfolio managers
– Alpha is the correct measure of performance, not total return
– Alpha takes into account the differences in risk among managers
§ Empirical research is mixed, but the framework is very useful

The CAPM and APT Slide 28