Columbia Business School

AT THE VERY CENTER OF BUSINESS

B8306 Capital Markets and Investments

Spring 2023
Professor Brian P. Lancaster

Session 12: Portfolio Choice 3

The Market and the CAPM
blancaster.nyc@gmail.com 860-898-0436
 The Market and the CAPM
Last Session:
ü Efficient risk taking: MVE portfolio

ü Mixing risk-free and risky assets (complete portfolio)

ü There are thousands of risky assets, but we only want to invest

into the single portfolio with the best reward-risk trade-off
(MVE), highest Sharpe ratio.

ü Once we find this mean variance efficient (MVE) portfolio, we

combine it with the risk-free asset in an amount determined by
our risk aversion.

Spring 2023 Lancaster 2

 The Market and the CAPM
Today: The Market and the CAPM
§ Portfolio weights based on market capitalization
§ Market has the highest Sharpe ratio
§ Assets’ required returns are based on market betas

§ CAPM: builds on the idea that everyone holds the

unique best portfolio. Centerpiece of modern
finance.

Spring 2023 Lancaster 3

 Where We Are

§ Equity Valuation
§ Portfolio Optimization
§ The Capital Asset Pricing Model (CAPM)
§ CAPM Anomalies

Spring 2023 Lancaster 4

 Mixing Three Risky Assets
§ Before we had a two asset optimal portfolio.

§ Now, consider three risky assets, US, Europe, and now

Pacific stocks with returns below:
One stage DDM with infinite holding period LR Historical
Correlations
After fees E(r) Volatility US Europe Pacific
US Stocks 5.94% 17.85% US Stocks 1 0.755 0.450
Europe Stk 7.59% 21.48% Europe Stk 0.755 1 0.573
Pacific Stk 8.39% 29.45% Pacific Stk 0.450 0.573 1

§ Can we benefit by diversifying into Pacific stocks?

§ Example: What is the Sharpe ratio of a portfolio with 30% in

the US, 60% in Europe, and 10% in Pacific?
Spring 2023 Lancaster 5
 Step 1: A Three-Asset Portfolio:
US 30%, Europe 60%, Pacific 10%

§ Portfolio expected US
return: Europe Pacific
E(rp) = 0.3 × 0.0594 + 0.6 × 0.0759 + 0.1 × 0.0839 = 7.17%
§ Portfolio variance of three asset portfolio:
US US Europe Europe Pacific Pacific
weight volatility weight volatility weight volatility

var(rp) = 0.32 × 0.17852 + 0.62 × 0.21482 + 0.12 × 0.29452

US and Europe Cov + 2 × 0.3 × 0.6 × 0.755 × 0.1785 × 0.2148
US and Pacific Cov + 2 × 0.3 × 0.1 × 0.450 × 0.1785 × 0.2945
Europe and Pacific Cov + 2 × 0.6 × 0.1 × 0.573 × 0.2148 × 0.2945

Europe Pacific Europe Europe Pacific

weight weight Pacific Volatility Volatility
correlation
var(rp) = 0.03654
Spring 2023 Lancaster 6
 A Three-Asset Portfolio:
US 30%, Europe 60%, Pacific 10%
§ Portfolio expected return:
E(rp) = 0.3 × 0.0594 + 0.6 × 0.0759 + 0.1 × 0.0839 = 7.17%
§ Portfolio variance:
var(rp) = 0.32 × 0.17852 + 0.62 × 0.21482 + 0.12 × 0.29452
US and Europe + 2 × 0.3 × 0.6 × 0.755 × 0.1785 × 0.2148
US and Pacific + 2 × 0.3 × 0.1 × 0.450 × 0.1785 × 0.2945
Europe and Pacific + 2 × 0.6 × 0.1 × 0.573 × 0.2148 × 0.2945
var(rp) = 0.03654 US 30%-Eur 60%-Pac 10%
§ Portfolio volatility: Sharpe Ratio

sp = sqrt(var(rp)) = sqrt(0.03654) = 19.12%

§ US.-Eur.-Pac. Sharpe R = (7.17% – 1.82%)/19.12% = 0.280
Expected excess return Volatility

• Sharpe ratio increases again (vs US/Europe portfolio: .272)

with further diversification. 7
Spring 2023 Lancaster
 Step 2: Optimal Risky Portfolio: MVE
US 30%, Europe 60%, Pacific 10%
Inputs Expected Return Volatility See “Optimal Portfolio.xlsx”
in Tools folder on Canvas
US 5.94% 17.85%
Inputs are in Green
Europe 7.59% 21.48% Cells to adjust using Solver
Pacific 8.39% 29.45% are in Orange
T-bills 1.82% Cell that automatically adjusts
is in Blue
Correlations US Europe
Europe 0.755
Pacific 0.450 0.573

MVE Portfolio Weight

US 23.3% Use Solver to compute weights in B13 and
Europe 53.0% B14 to max cell B19
Pacific 23.7% = 1 – sum of weights on US and Europe

Expected Return 7.39%

By optimizing we improve
Volatility 19.60%
Sharpe ratio to .284 from .280 and
Sharpe Ratio 0.284
ools

Expected Return to 7.39%

Spring 2023 Lancaster 8
 Step 3: Optimal Complete Portfolio:
How Much Risk Free Asset – T-bills?

Overall Portfolio Weights

Risk Aversion 2.0

Europe
Weight on MVE 72.52%
38.44%
Overall Weight 27.48% MVE 72.52% US 16.92%
US 16.92%
Europe 38.44% 17.17%
Pacific 17.17%
Asia
T-bills 27.48%

T-bills US Europe Pacific

• Now that we have the MVE let’s determine how much risk we prefer (MVE and
T-Bill mix). Based on risk aversion A=2; 72.52% MVE % & 27.48% T-bills.
See “Optimal Portfolio.xlsx” in Tools folder on Canvas

Spring 2023 Lancaster 9

 Practical
“My ventures are not in one
bottom trusted. Therefore my
merchandise makes me not sad.”

Diversification The Merchant of Venice, 1596 AD

§ Holding a few low-cost index funds can suffice

§ Vanguard total stock, bond, and int’l stock market index funds

§ Asset allocation is crucial

§ Mix US and foreign stocks and bonds
§ Adding low-correlation assets can help

§ Don’t invest too much in any single asset

§ Most indexes avoid overweighting single assets
§ If you pick single stocks or bonds, do so in moderation

Spring 2023 Lancaster 10

 Three-Asset Example:
Investors’ Actual Portfolios

Market portfolio: all risky assets held in

proportion to their market capitalizations

Market Cap. % of Risky % of Total

Asset Class (Adj.) in $B (Market Portfolio) (Complete Port.)
US Stock $29,300 64.7% 61.6%
Europe Stock $9,400 20.7% 19.7%
Pacific Stock $6,600 14.6% 13.9%
Total Risky $45,300 100.0% 95.2%

Treasury Bills $2,300 4.8%

All Assets $47,600 100.0%

Spring 2023 Lancaster 11

 CAPM: Prices (E(r)) Adjust Until Given
Market Port. Wts. Produce an Optimal
Sharpe Ratio
Inputs Expected Return Volatility
US 7.54% 17.85%
Europe 8.21% 21.48%
Pacific 8.57% 29.45%
T-bills 1.82%
Correlations US Europe
Europe 0.755
Pacific 0.450 0.573

MVE (Mkt) Portfolio Weight

US 64.7% Use Solver to compute weights in
Europe 20.7% B13 and B14 to max cell B19
Pacific 14.6% = 1 – sum of US & Europe weight

Expected Return 7.83%

Volatility 17.77%
Spring 2023 Sharpe Ratio 0.338
See “CAPM Calculations.xlsx” on Canvas. Expected returns in yellow come from the CAPM 12
formula with beta * mkt premium Lancaster
 CAPM: Prices (E(r)) Adjust Until
Market Port. Wts. Are Optimal
Inputs Expected Return Volatility
US 7.54% 17.85%
Europe 8.21% 21.48%
Pacific 8.57% 29.45%
T-bills 1.82%
Correlations US Europe
Europe 0.755
Pacific 0.450 0.573

MVE (Mkt) Portfolio Weight

US 64.7% Use Solver to compute weights in
Europe 20.7% B13 and B14 to max cell B19
Pacific 14.6% = 1 – sum of US & Europe weight

Expected Return 7.83%

Volatility 17.77%
Spring 2023 Sharpe Ratio 0.338
See “CAPM Calculations.xlsx” on Canvas. Expected returns in yellow come from the CAPM 13
formula with beta * mkt premium Lancaster
 CAPM: Market Is the MVE
§ Each rational investor chooses the risky portfolio that offers the best
reward-risk trade-off: the MVE portfolio*

§ A basic principal 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 portfolios selling one and
buying the other. Such activity would impart pressure on security
prices until the ratios were equalized.

*Remember from Session 10, the optimal risky portfolio, the mean variance efficient
(MVE) portfolio has the highest Sharpe ratio (SR) (highest expected excess return or risk
premium per unit of risk (volatility).

Spring 2023 Lancaster 14

 CAPM: Market Is the MVE
§ Each rational investor chooses the risky portfolio that offers the best
reward-risk trade-off: the MVE portfolio*

§ If all investors holds the same beliefs about risky assets’ expected
returns, volatilities, and correlations**, they all choose (i.e., demand)
the same Mean Variance Efficient (MVE) portfolio

§ Asset prices adjust until investor demands (MVE) equal the

supply of all risky assets—i.e., the market

*Remember from Session 10, the optimal risky portfolio, the mean variance efficient (MVE)
portfolio has the highest Sharpe ratio (SR) (highest expected excess return or risk premium
per unit of risk (volatility).

**One set of key assumptions of the CAPM model.

Spring 2023 Lancaster 15
 CAPM: Market Is the MVE
§ Asset prices adjust until investor demands (MVE) equal the supply of
all risky assets—i.e., the market

§ Example: Assume the optimal portfolio of our investors doesn’t

include a company’s stock, e.g. Delta airlines, that is in the market
MVE portfolio. When all investors avoid Delta stock, the price falls. As
Delta stock gets cheaper it becomes ever more attractive and other
stocks less relatively attractive. At some point, Delta falls to a price
where it is attractive enough to include in the optimal stock portfolio.

§ Such a price adjustment process guarantees that all stocks (and

assets) will be included in the market portfolio.

§ The only issue is the price at which investors will be willing to include
a stock in their optimal portfolio.
Spring 2023 Lancaster 16
 Expected Returns for
Investors Who Optimize
§ To maximize Sharpe ratio, an investor adjusts weights on
assets to equate their marginal reward-risk ratios
§ Asset’s MVE beta is the sensitivity of its’ return to MVE return
Pacific stock excess return Market Excess Return
or Pacific risk premium or MVE risk premium

E[ri ] - rf = bi , MVE ´ éë E[rMVE ] - rf ùû

§ E.g., if Pacific stock moves 1.12x as much as the investor’s MVE

portfolio, Pacific risk premium must be 1.12x the MVE premium

§ Interpretation: Each asset’s expected return compensates

the investor for the asset’s beta with her portfolio
§ The compensation per unit of beta is her portfolio’s risk premium

Spring 2023 Lancaster 17

 • Theoretically all prices should be migrating to a level such that the
expected excess return of that asset will be equal to the expected
excess return of the market times the relative riskiness of that asset
to the market which is beta.

• Thus if we can figure out the theoretical expected return of an asset

using CAPM formula, which we call the required return, we can use
that to discount the cash flows of the asset to calculate it’s value.

• We can then compare it’s price in the market to the value. If the
price is less than the value we calculate using CAPM, we buy
because theoretically the asset is under priced in the market and its’
price should gradually rise to the CAPM value making us money.

Spring 2023 Lancaster 18

 CAPM Intuition
§ Market must be efficient for rational investors to hold it

§ Investors like (negative β) assets with high returns when the rest of
their portfolio (the market) has low returns
§ Negative β assets provide insurance à high price, low E(r)
§ Positive β assets provide anti-insurance à low price, high E(r)

§ Compare two assets: Automobile stocks vs. US T-bonds

§ Automobile stocks: β = 1.40, so k = 2% + 1.40 × 5% = 9%
§ US T-bonds: β = –0.20, so k = 2% + –0.20 × 5% = 1%

§ Automobile stocks are more volatile, risky, than the market so the
expected return, k, needs to be high (9%). T bonds less volatile, less
risky and move opposite market so expected return, k, will be low (1%).
Spring 2023 Lancaster 19
 CAPM in Philosophy

§ Financial assets, like friends or spouses, are more

valuable if they help you when you need help

“Lots of people want to ride with you in the limo, but

what you want is someone who will take the bus with
you when the limo breaks down.” – Oprah Winfrey

“There is no possession more valuable than a good

and faithful friend.” – Socrates

Spring 2023 Lancaster 20

 CAPM in Music
§ Ray Charles in 1954
§ Topic: (highly valued) negative beta friend
§ “She gives me money when I’m in need”
§ “Yeah, she’s a kind friend indeed”

§ Jamie Foxx and Kanye West in 2005:

§ Topic: (lowly valued) positive beta friend
§ “She takes my money while I’m in need”
§ “Yeah, she’s a trifling friend indeed”

“Shoulda gotta that insured, GEICO, for your money”

Example of negative beta asset: long-term Treasuries in the 2008-2009 financial crisis (flight to safety) or
recent coronavirus scare. Positive beta asset: cyclical US stock, such as Caterpillar.
Spring 2023 Lancaster 21
 CAPM Implications
CAPM describes prices and portfolios if investors are rational

1) Market has the highest Sharpe ratio (MVE)*

§ All (rational) investors hold the market

E[rM ] - rf
SR p £ SRM =
sM
2) Assets’ expected excess returns increase with market beta
§ Beta: marginal risk added to investors’ (market) portfolios
§ Market risk premium: required return per unit of market beta

E[ri ] - rf = biM ´ éë E[rM ] - rf ùû

*Highest expected excess return per unit of risk.
Spring 2023 Lancaster 22
 CAPM Portfolio Choice
§ Everybody holds the same risky portfolio (MVE), namely
the market portfolio, and mixes it with the risk-free asset
§ Risk-averse investors hold relatively more risk-free asset (T-Bills)
§ Risk-tolerant investors hold relatively more risky assets (market)

§ CAPM: Market = all risky assets weighted by market cap

§ Simple example: Market = All US stocks (CRSP index*)

§ CRSP US stock index weights stocks by (free “float”) market cap
§ E.g., MSFT wt = 3.51% = MSFT mkt cap / US total mkt cap = 1.03T / 29.3T

*The Center for Research in Securities Prices (CRSP) index include stock market securities trading on the
New York Stock Exchange, New York Stock Exchange Market (formerly AMEX), ARCA, and NASDAQ. ...
The indexes are weighted according to free-float market capitalization and are recalculated quarterly.
Spring 2023 Lancaster 23
 What Do Investors Hold?
§ “Market” index funds are popular (~$4T assets)*
§ Index, such as S&P500, funds are growing rapidly
§ Top two funds (VFIAX, SPY) have $750B in AUM
§ Expense ratios (i.e., costs) are low, just 0.04% and 0.09%

§ Many fund managers use US mkt index as a benchmark

§ Compare fund weight in MSFT to stock’s 3.51% US mkt weight
§ Overweight (underweight) means over (under) 3.51% index weight
§ Activity of a manager is often measured relative to the market
(i.e. how much “alpha” are they generating)
§ Highly active managers choose weights that deviate a lot from the market

*Idea: If the market is the MVE portfolio (where you get the most return per unit of risk) why not just
invest LT in an index, such as the S&P500, via a low fee fund, that represents the market?

Spring 2023 Lancaster 24

0.49%
-------
 What Is the Market?

§ Stocks, risky bonds, private equity, real estate, etc.

§ Public stocks are just 1/3 of household net worth

§ Human capital is a risky asset, too

§ Capital income is 2/5 of US income (wages are 3/5)

§ Domestic and foreign assets

§ US wealth is 2/5 of global wealth (US GDP is 1/4 of global GDP)

§ US public stocks are 1/3 × 2/5 × 2/5 = 5.3% of market

§ MSFT stock is thus just 3.51% × 5.3% = 0.19% of the market

Spring 2023 Lancaster 26

 What Is the
Market Risk Premium?
§ Ideal weight on the market in the complete portfolio is:
Market excess return
Or market risk premium Market excess return Market risk
Or market risk premium or volatility
E[rMkt ] - rf
w *
Mkt = E[ rMkt ] - rf = wMkt
*
Aσ 2Mkt
Aσ 2Mkt
Investor’s degree
of risk aversion
§ Premium gets investor to hold the market given its risk
§ Assume investors’ weight on the market is close to 1.0
§ wmkt = 0.9517 in our three-asset example (higher w/ more assets)

§ Market risk premium with A = 2 and volatility of 15%

E[rMkt ] - rf » 1.0(2)(0.15) 2 = 4.5%

*Intuitively: Imagine the market is perceived to be twice as risky (A=2) by all participants then the market’s 27
excess risk premium has to be twice as much as when the market was perceived by all to be less risky (A=1).
 Risk Premium Can Vary
§ Risk premium increases with risk aversion and volatility
§ Risk aversion and volatility often increase in recessions
§ As the risk premium increases, risky (e.g., stock) asset prices fall
§ Small premium changes can cause huge price drops by boosting “k”
required return (recall DDM)
§ Traders refer to this dynamic as: “Risk on, risk off”

Market Risk Implied Risk

In a recession Economy Weight Aversion Volatility Premium
risk aversion “A”
Boom 100% 1.00 15% 2.25%
increases from
2 to 4 causing Normal 100% 2.00 15% 4.50%
risk premium Recession 100% 4.00 15% 9.00%
to double, stock Volatile 100% 2.00 25% 12.50%
prices to fall.
The Average 2021 market risk premium was 5.5% up from a low of 4.06% in 2019. In
March 2020, the market risk premium went up to 6%. It is currently about 5.8%
Spring 2023 Lancaster 28
 What Is Reasonable
Investor Risk Aversion?
§ Investors allocations to risky assets range quite a bit
§ So do investor expectations of market returns
§ Risky asset allocations reflect both expectations and risk aversion
Market Expected Risk Implied Risk
Investor Weight Premium Volatility Aversion
Diego 40% 4.0% 20% 2.50 Example:
Jasmine who is
Elizabeth 80% 4.0% 20% 1.25
very risk averse
Jasmine 40% 8.0% 20% 5.00 (A=5) only
holds 40% in
Peter 80% 8.0% 20% 2.50
the market
Portfolio.
E[ rMkt ] - rf = wMkt
*
Aσ 2Mkt

§ Risk aversion (A) values range between 1.25 and 5.00

§ Appendix: Our A values range between 1/3 and 6
Spring 2023 Lancaster 29
 What’s the Market Sharpe Ratio (SR)?

§ Suppose the market is the S&P 500

§ Estimate of market risk premium* = 5% 0.05
SRM = = 0.333
§ Estimated of expected volatility = 15% 0.15

§ Consistently beating the market is surprisingly hard

§ “Huge institutional investors… have long underperformed the
unsophisticated index-fund investor who simply sits tight.”
§ Warren Buffett (2014)

*Excess return over the risk free rate.

Spring 2023 Lancaster 30

 Applying the CAPM

CAPM is very useful despite flaws in its predictions

§ In reality – risky portfolio is everything risky - bonds, real estate, foreign assets,
privately held businesses and human capital. These assets must be traded.
§ The CAPM makes a counterfactual assumption that beliefs are the same, but it‘s still
super useful!

§ Simple advice for portfolio choice

§ Invest in the market portfolio (with market-cap weights). In past
few years index funds have become huge, growing much faster
than actively managed funds. (E.g Vanguard $5T v Fidelity $2.5T)

§ Impetus for index funds

§ Picking individual assets just adds unnecessary risk
Spring 2023 Lancaster 31
 More Uses of the CAPM

CAPM is very useful despite flaws in its predictions

§ Benchmark for evaluating investment performance

§ Portfolio must beat the market after adjusting for risk
§ (CAPM) alpha = expected return – (CAPM) required return*

§ Many CFOs use CAPM to find cost of capital

§ Investment must beat the market after adjusting for risk* (see slide 18)

§ Making positive NPV investments increases firm value*

* What does CAPM say about alpha in an efficient market?

**Required returns needed as inputs for valuation models.
Spring 2023 Lancaster 32
 Summary of the CAPM

§ The CAPM makes predictions that are useful benchmarks

§ Beta is the only risk that affects required and expected returns
§ Required returns based on beta can be used as discount rates
§ Required and expected returns are equal in CAPM (mkt. efficiency)
§ No high (or low) risk-adjusted returns; all securities’ alphas are zero

§ All investors hold the market as their risky portfolio

§ The market has the highest Sharpe ratio (it can’t be beaten)
§ Market risk premium increases w/ risk aversion and volatility

Spring 2023 Lancaster 33

 Logistics and Reminders

§ Problem Set 2 is due before 8:30AM on March 5

§ Midterm practice exam is on Canvas.

§ Midterm: Mar 6 6PM to Mar 12 11:59pm on Canvas

§ Open notes and book, but no communication with others

§ Optional midterm review sessions before the exam

§ Contact TAs.

Spring 2023 Lancaster 34

 Appendix:
CAPM Equations (1)

1. The market (M) is MVE if and only if, for all portfolios p:
SRM ³ SR p

2. If the market is MVE, then E(r) = k for all assets i, so:

E[ri ] - rf = biM ´ éë E[rM ] - rf ùû

Spring 2023 Lancaster 35

 CAPM Equations (2)

3. Market premium increases with risk aversion and volatility:

E[rMkt ] - rf = wMkt
*
Aσ 2Mkt » Aσ 2Mkt

4. Portfolio’s beta is a weighted average of its assets’ betas:

b p = å wi ×bi
i

Spring 2023 Lancaster 36

 Appendix:
Reasonable Risk Aversion

§ Which portfolio do Cap Markets students prefer?

Expected % of Implied Risk Utility for Utility
Portfolio Return Volatility Students Aversion A = 1/3 for A = 6
1 9% 50% 31% A < 1/3 0.0483 –0.6600
2 5% 10% 65% 1/3 < A < 6 0.0483 0.0200
3 2% 0% 4% A>6 0.0200 0.0200

§ If A = 6, utilities of portfolios 2 and 3 both equal 0.02

§ 0.05 – ½ × 6 × (0.10)2 = 0.02 – ½ × 6 × (0)2 = 0.02
§ And these portfolios beat portfolio 1, which has U = –0.66

Spring 2023 Lancaster 37

 Appendix:
Interpreting Risk Aversion

§ Personal question: What’s the lowest risk premium (RP) in

% that would make you prefer a risky portfolio with
14.1% (sqrt(0.02)) volatility to a risk-free (rf) portfolio?
§ Answer: Your degree of risk aversion (A)!

§ Example: If lowest premium (RP) is 3%, then A = 3

§ To see why, set utilities of risky and risk-free equal

§ rf + RP – ½ × A × (sqrt(0.02))2 = rf + 0 – ½ × A × (0)2
§ A = RP × 100

Spring 2023 Lancaster 38