CHAPTER 7: CAPITAL ASSET PRICING MODEL

Asset allocation: Portfolio picking amongst all the assets available at the market. Its goal is
to find the best possible combination between risk and return (technical).
Portfolio (C): The whole portfolio including risk asset
Capital allocation: choosing the % of portfolio C invested in a risk Portfolio (P) and the
risk-free asset (R).

7.1 The capital asset pricing model

The capital asset pricing model is a set of predictions concerning equilibrium expected
returns on risky assets. It's a model that relates the required rate of return on a security to its
systematic risk as measured by beta. The model is based on the fact that individuals are
equal in everything except their initial amount of investment and their risk aversion.

The CAPM asks what would happen if all investors shared an identical investable universe
and used the same input list to draw their efficient frontiers. Obviously, their efficient frontiers
would be identical. Facing the same risk-free rate, they would then draw an identical tangent
CAL and naturally all would arrive at the same risky portfolio, P. A key insight of the CAPM is
that, because the market portfolio is the aggregation of all of these identical risky portfolios, it
too will have the same weights. Therefore, if all investors choose the same risky portfolio, it
must be the market portfolio, that is, the value-weighted portfolio of all assets in the
investable universe. Therefore, the capital allocation line based on each investor’s optimal
risky portfolio will in fact also be the capital market line.

The CAPM is:

- A set of predictions concerning equilibrium expected returns on risky assets.
- The equilibrium model that underlies all modern financial theory.
- Derived using principles of diversification with simplified assumptions.

CAPM assumptions:
1. Investors use identical inputs lists for efficient frontier.
2. Same risk-free rate, tangent CAL and risky portfolio.
3. Market portfolio is aggregation of all risky portfolios and has the same weights.
ß measures the degree in which the return of an asset reacts to the returns of the market
portfolio. “1” is the weighted-average value of beta across all assets. If the market beta is 1,
and the market is a portfolio of all assets in the economy, the weighted average beta of all
assets must be 1. Hence, betas greater than 1 are considered aggressive in that investment
in high-beta stocks entails above-average sensitivity to market swings. Betas below 1 can be
described as defensive.

- The CML is the CAL that is constructed from a money market account (or T-bills) and
the market portfolio. In the simple world of the CAPM, M is the optimal tangency
portfolio on the efficient frontier.
- Market portfolio contains all securities and the proportion of each security is its
market value as a percentage of total market value.

Market risk premium:

The risk premium on the market portfolio will be proportional to its risk and the degree of risk
aversion of the investor:

Each individual investor chooses a proportion y allocated to the optimal portfolio such:

*When investors purchase stocks, their demand drives up prices, thereby lowering expected
rates of return and risk premiums. But when risk premiums fall, investors will move some of
their funds from the risky market portfolio into the risk-free asset. In equilibrium the risk
premium on the market portfolio must be just high enough to induce investors to hold the
available supply of stocks. If the risk premium is too high, there will be excess demand for
securities, and prices will rise; if it is too low, investors will not hold enough stock to absorb
the supply, and prices will fall. The equilibrium risk premium of the market portfolio is
therefore proportional both to the risk of the market, as measured by the variance of its
returns, and the degree of risk aversion of the average investor, denoted by A.

Return and risk for individual securities.

The risk premium on individual securities is a function of the individual security’s contribution
to the risk of the market portfolio.
An individual security’s risk premium is a function of the covariance of returns with the assets
that make up the market portfolio.
The last equation is often called the market price of risk because it quantifies the extra return
that investors demand to bear portfolio risk.
A basic principle of equilibrium is that all investments should offer the same reward-to-risk
ratio. If the ratio were better for one investment than another, investors would rearrange their
portfolio, tilting toward the alternative with the better trade-off and shying away from the
other. Such activity would impart pressure on security prices until the ratios were equalized.
Therefore we conclude that the reward-to-risk ratios of GE and the market portfolio should
be equal.
In words, an asset’s risk premium equals the asset’s systematic risk measure (its beta) times
the risk premium of the (benchmark) market portfolio. Only systematic risk matters to
investors who can diversify, and systematic risk is measured by beta.

The fact that many investors hold active portfolios that differ from the market portfolio does
not necessarily invalidate the CAPM. Recall that reasonably well-diversified portfolios shed
almost all firm-specific risk and are subject to only systematic risk. Even if one does not hold
the precise market portfolio, a well-diversified portfolio will be so highly correlated with the
market that a stock’s beta relative to the market still will be a useful risk measure.

A word of caution: We often hear that a well-managed firm will provide a high rate of return.
This is true when referring to the firm’s accounting return on investments in plant and
equipment. The CAPM, however, predicts returns on investments in the securities of the firm
that trade in capital markets.

Meaning of ß:
- A beta of 1 indicates that the security’s price moves with the market.
 - A beta of less than 1 means that the security is theoretically less volatile than the
market. If a stock’s beta is 0.65, it is theoretical 35% less volatile than the market.
Therefore, this stock’s excess return is expected to underperform the benchmark by
35% in up markets and outperform by 35% during down markets.
- A beta greater than 1 indicated that the security’s returns are theoretically more
volatile than the market (highly sensitive). If a stock’s beta is 1.2, it’s theoretically
20% more volatile than the market.

The security market line

The SML is the graphical representation of the expected return-beta relationship of the
CAPM. Its slope is the risk premium of the market portfolio. At the point where ß=1, we can
read off the vertical axis the expected return on the market portfolio.
The CML graphs the risk premiums of efficient complete portfolios (made up of the market
portfolio and the risk-free asset) as a function of portfolio standard deviation. The SML, in
contrast, graphs individual-asset risk premiums as a function of asset risk. The relevant
measure of risk for an individual asset (which is held as part of a well-diversified portfolio) is
not the asset standard deviation, but rather the asset beta. The SML is valid both for
individual assets and portfolios.
The security market line provides a benchmark for evaluation of investment performance.
The SML provides the required rate of return that will compensate investors for the beta risk
of that investment, as well as for the time value of money.
Alpha is the abnormal rate of return on a security in excess of what would be predicted by
an equilibrium model such as the CAPM.
Essentially, alpha is the difference between fair and actual expected rates of return on a
stock.
Applications of CAPM
- Use SML as benchmark for fair return on risky asset
- SML provides “hurdle rate” for internal projects

Assumptions of the CAPM

1. Individual behavior
a. Investors are rational, mean-variance optimizers
b. Their planning horizon is a single period
c. Investors have homogeneous expectations (identical input lists)
2. Market structure
a. All assets are publicly held and traded
b. All information is publicly available
c. No taxes
d. No transaction costs

Liquidity and the CAPM

Liquidity is the ease and speed with which an asset can be sold at fair market value.
Illiquidity can be measured in part by the discount from fair market value a seller must
accept if the asset is to be sold quickly. A perfectly liquid asset is one that would entail no
illiquidity discount.
Illiquidity premium is the discount from fair market value the seller must accept to obtain a
quick sale. It’s measured partly by bid-asked spread. And as trading costs are higher, the
illiquidity discount will be greater. We should expect less-liquid securities to offer higher
average rates of return.
During a financial crisis, liquidity can unexpectedly dry up. When liquidity in one stock
decreases, it tends to decrease in other stocks at the same time.
Investors demand compensation for liquidity risk (liquidity betas).