FRM® PREPARATION COURSE

THE STANDARD CAPITAL

ASSET PRICING MODEL
[01.FRM.09]

FRM SPREADSHEETS
 1.FRM.09a. - Portfolio Curve.xls
 1.FRM.09.b. - Diversification.xls
 1.FRM.09.c. - Efficient Porfolio.xls
 1.FRM.09.d. - CML SML

FOUNDATIONS OF RISK MANAGEMENT

 FRM®
FRM Program Manual

The Standard Capital Asset Pricing Model

After completing this reading the FRM candidate should be able to:

 Understand the derivation and components of the CAPM.

 Describe the assumptions underlying the CAPM.
 Interpret the capital market line.
 Apply the CAPM in calculating the expected return on an asset.
 Interpret beta and calculate the beta of a single asset or portfolio.

THE STANDARD CAPITAL ASSET PRICING MODEL 2

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Key Learning Objetives

1 Portfolio Theory

1 Assumpions of the CAPM

2 Portfolio Possibilities Curve and Efficient Portfolio

3 Capital Market Line

4 Market Beta and Market Premium

5 Security Market Line

THE STANDARD CAPITAL ASSET PRICING MODEL 3

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Portfolio Theory

Portfolio Expected Return

Key Formula

 The return of a portfolio with two or more assets is the weighted sum
of the individual returns

 For example, with two assets

E(RP) = wA E(RA) + wB E(RB)

THE STANDARD CAPITAL ASSET PRICING MODEL 4

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Portfolio Theory

Portfolio Variance

and Volatility
2
.
 2

Key Formulas
 Variance of a portfolio of two (or more) assets

σ2p= wA2 σ2A + wB2 σ2B + 2 wAwB Cov (RA,RB)

σ2p= wA2 σ2A + wB2 σ2B + 2 wAwB ρA,B σA σB

– It is not the weighted average of asset volatilities (as for portfolio

returns)
– This is due to the interaction between assets (correlation)

 Volatility = σ= 
2

THE STANDARD CAPITAL ASSET PRICING MODEL 5

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Portfolio Theory

Correlation and Diversification

FRM Spreadsheet: Porfolio Curve

 Correlation = ρA,B = Cov (RA,RB) / σA σB , where ρ [-1;+1]

 Diversification benefits
.
The lower the correlation (ρ
close to -1) the greater the
diversification (lower risk)
The higher the correlation (ρ
close to +1), the lower the
benefit of diversification

THE STANDARD CAPITAL ASSET PRICING MODEL 6

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Portfolio Theory

Correlation and Diversification

FRM Spreadsheet: Porfolio Curve

 How the Portfolio Possibilities Curve changes according to
different levels of correlation

 If there is no diversification,
(ρ = 1) the Portfolio
Possibilities Curve is a
straight line
 The more convex the line is,
the higher the diversification
benefits (lower correlation)

THE STANDARD CAPITAL ASSET PRICING MODEL 7

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Key Learning Objetives

1 Portfolio Theory

1 Assumpions of the CAPM

2 Derivation of the CAPM

3 Capital Market Line

4 Market Beta and Market Premium

5 Security Market Line

THE STANDARD CAPITAL ASSET PRICING MODEL 8

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Assumptions of the CAPM

The Capital Asset Pricing Model (CAPM)

Key Assumptions
 No transaction costs
 Assets are infinitely divisible
 Investment horizon is one single period
 There are no taxes
 Markets are perfectly competitive
 Investors decisions are based on expected portfolio return and risk
 Short-selling allowed

THE STANDARD CAPITAL ASSET PRICING MODEL 9

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Key Learning Objetives

1 Portfolio Theory

1 Assumpions of the CAPM

2 Portfolio Possibilities Curve and Efficient Portfolio

3 Capital Market Line

4 Market Beta and Market Premium

5 Security Market Line

THE STANDARD CAPITAL ASSET PRICING MODEL 10

 Portfolio Possibilities Curve and FRM®

Efficient Portfolio
Risk and Return Combinations

FRM Spreadsheet: Efficient Porfolio

w(A)=80% E(Rp) = 80%*5% + 20%*3% = 4,60%

w(B)=20% σp = ( 80%^2*10%^2 + 20%^2*8%^2 +
+ 2(-0,4)*80%*20%*10%*8% = 7,50%)

THE STANDARD CAPITAL ASSET PRICING MODEL 11

 Portfolio Possibilities Curve and FRM®

Efficient Portfolio
The Portfolio with the Smallest Variance

FRM Spreadsheet: Efficient Porfolio

 Portfolio with the smallest variance among all portfolio
combinations (the portfolio possibilities curve)

 Left-most point on the

portfolio possibilities
curve

2-assets portfolio
w1= [σ22 – ρ1,2 σ1σ2] / [σ12 + σ22 - 2 ρ 1,2σ1σ2]
w2 = 1- w1

THE STANDARD CAPITAL ASSET PRICING MODEL 12

 Portfolio Possibilities Curve and FRM®

Efficient Portfolio
Efficient Frontier

Less risky portfolios for each level of return

 All portfolios located UNDER the dotted red line are inefficient

100% Asset A, 0% Asset B

0% Asset A, 100% Asset B

 Markowitz Efficient portfolios = all the combinations located ABOVE

dotted line
THE STANDARD CAPITAL ASSET PRICING MODEL 13
 FRM®
Key Learning Objetives

1 Portfolio Theory

1 Assumpions of the CAPM

2 Portfolio Possibilities Curve and Efficient Portfolio

3 Capital Market Line

4 Market Beta and Market Premium

5 Security Market Line

THE STANDARD CAPITAL ASSET PRICING MODEL 14

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Capital Market Line

Finding the Efficient Portfolio

Markowitz Porftolio

 Efficient Portfolio = Market Portfolio

– The one that maximizes the Sharpe Ratio

 Sharpe Ratio = [E(RP) – Rf] / σp

– The Market Portfolio is one of the portfolios located on the

Efficient Frontier

THE STANDARD CAPITAL ASSET PRICING MODEL 15

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Capital Market Line

Finding the Efficient Portfolio With Short Sales

FRM Spreadsheets: CML SML

 CAPM model allows short selling

 Efficient Frontier shape

─ It expands up to the right side of the graph
With short sales
the curve moves
to the right

THE STANDARD CAPITAL ASSET PRICING MODEL 16

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Capital Market Line

Finding the Efficient Portfolio

FRM Spreadsheets: CML SML

 Vol (P) = √ ( 60%2 * 10%2 + 40%2 * 8%2 + 2* 0,2 * 40% * 60% *

10% * 8% ) = 7,34%
 Sharpe = 4,20% - 1% / 7,34% = 0,4358
THE STANDARD CAPITAL ASSET PRICING MODEL 17
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Capital Market Line

Efficient Frontier with Risk Free Asset

FRM Spreadsheet: CML SML

 Capital Market Line
– When a risk free asset is
combined with the Market
Portfolio, the resulting
risk/return combinations
will lie on a straight line
tangent to the Efficient
Frontier
 This straight line is known as Capital Market Line (CML)
 The point of tangency is the Market Portfolio

THE STANDARD CAPITAL ASSET PRICING MODEL 18

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Capital Market Line

Market Portfolio and CML

Key Concepts
 Combining the
Market Portfolio
(the most efficient
portfolio) with the Portfolio possibilities curve
risk free asset
gives us the CML
(Capital Market
Line)

 E ( RM )  RF )   E ( RM )  RF ) 
E ( Ri )  RF   i   Slope of CML     Sharpe Ratio
  M    M 

THE STANDARD CAPITAL ASSET PRICING MODEL 19

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Key Learning Objetives

1 Portfolio Theory

1 Assumpions of the CAPM

2 Portfolio Possibilities Curve and Efficient Portfolio

3 Capital Market Line

4 Market Beta and Market Premium

5 Security Market Line

THE STANDARD CAPITAL ASSET PRICING MODEL 20

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Market Beta and Market Premium

Diversifiable and Systematic Risk

Key Concepts
 Diversifiable Risk
– The part of the volatility of a single security’s returns that is
uncorrelated with the volatility of the market portfolio

 Systematic Risk
– The part of the volatility of a single security’s returns that is
correlated with the volatility of the market portfolio

 When a risky security is added to a well-diversified (efficient)

portfolio, the portfolio’s risk is only affected by the systematic risk of
that security

THE STANDARD CAPITAL ASSET PRICING MODEL 21

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Market Beta and Market Premium

Market Beta

Units of Systematic Risk

 The Systematic Risk (Market Risk) of a security is measured by its
beta (β)

 Units of Market Risk which a single security represents

 It depends on the covariance between the security and the market

portfolio
Beta, β = Cov (Ri, Rm) / σ2m

– Portfolio Beta is the weighted average of individual securities

Betas

THE STANDARD CAPITAL ASSET PRICING MODEL 22

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Market Beta and Market Premium

Market Premium

Price of Systematic Risk

 For each unit of market risk (β, beta), investors can expect to receive a
premium over risk free return

 Premium per unit of market risk [E(RM) – RF]

– E(RM): Market Portfolio Return
– RF: Risk Free asset return

 Total premium for an investment is calculated as

Units of Risk x Price of Risk: β [E(RM) – RF]

THE STANDARD CAPITAL ASSET PRICING MODEL 23

 FRM®
Key Learning Objetives

1 Portfolio Theory

1 Assumpions of the CAPM

2 Portfolio Possibilities Curve and Efficient Portfolio

3 Capital Market Line

4 Market Beta and Market Premium

5 Security Market Line

THE STANDARD CAPITAL ASSET PRICING MODEL 24

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Security Market Line

Beta, Market Premium and SML

Key Concepts
 Equation of the Security Market Line (SML)
– With efficient diversification, there is no extra expected return for
bearing diversifiable risk

 Expected return in equilibrium

Expected return of any security is the
riskless rate of interest plus the market
price of risk times the amount of risk in
the security or portfolio

 E(Ri) = RF + βi [E(RM) – RF]

THE STANDARD CAPITAL ASSET PRICING MODEL 25

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Security Market Line

Beta, Market Premium and SML

FRM Spreadsheet: CML SML

Beta = 0,763 = 0,005 / (7,84%^2)

E(Rp) = 3,59%= 1% + 0,763 * (4,40% - 1%)

THE STANDARD CAPITAL ASSET PRICING MODEL 26

 FRM®
FRM Questions

CAPM Assumptions
Sample Question
Which of the following is CORRECT regarding the capital asset pricing model (CAPM)? The
CAPM:

A) assumes there are taxes and transactions costs.

B) assumes investors prefer lower risk given a level of return.
C) applies to non-normally distributed returns.
D) assumes that investors’ expectations regarding risk and return are not identical, but
normally distributed.

CORRECT: B
The CAPM assumes that: investors are risk adverse, there are no taxes or transaction
costs, returns are normally distributed, investors’ expectations for risk and return are
identical.

THE STANDARD CAPITAL ASSET PRICING MODEL 27

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FRM Questions

Security Market Line

Sample Question
Which of the following statements about the security market line (SML) is least accurate?

A) The market portfolio consists of all risky assets.

B) Securities that plot above the SML are undervalued.
C) The risk-free rate defines where the SML intersects the vertical axis.
D) Securities that plot on the SML have no intrinsic value to the investor.

CORRECT: D
Securities that fall on the SML are properly priced. They have value to an investor in that
they still earn a return.

THE STANDARD CAPITAL ASSET PRICING MODEL 28

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FRM Questions

Portfolio Variance
Sample Question
Consider a portfolio with 40% invested in asset X and 60% invested in asset Y. The mean
and variance of return on X are 0 and 25 respectively. The mean and variance of return on Y
are 1 and 121 respectively. The correlation coefficient between X and Y is 0.3. What is the
nearest value for portfolio volatility?
a. 9.51%
b. 8.60%
c. 13.38%
d. 7.45%

CORRECT: D
σ2p= wA2 σ2A + wB2 σ2B + 2 wAwB ρA,B σA σB
σ2p = 0,4^2 *25 +0,6^2 * 121 + 2*0,4*0,6*0,3*5*11 = 55,48
σp = (55,48)^0,5 = 7,45

THE STANDARD CAPITAL ASSET PRICING MODEL 29