Financial Investments

CAPM
Treynor Sharpe 1990
Chapter 5 (1961) (1961, 1963, 1964)

Nelson Areal
Management Department

Lintner Mossin Black

(1965) (1965) (1972)

Capital Asset Pricing Model - CAPM Capital Asset Pricing Model - CAPM

Assumptions
We assume that investors:
O

• risk averse; • single investment horizon;

• rational; • all assets are traded/or

investments are limited to traded
• prefer more to less; financial assets;

• information is costless and • no taxes and transaction costs;

available to all investors;
• no limits to lending and borrowing
• have homogeneous expectations; at the risk-free rate

• price takers.
Capital Asset Pricing Model - CAPM Capital Asset Pricing Model - CAPM

All investors hold the same portfolio of

risky assets

How do we get
M

M
from this

The market portfolio contains all securities

to this? E[ri ] = rf + i (E[rm ] rf )
Market value of the individual security
wi =
Market value of all assets

Capital Asset Pricing Model - CAPM Capital Asset Pricing Model - CAPM

The passive strategy is efficient

The market risk premium depends on the
average risk aversion of all investors
Mutual fund theorem: All investors desire same portfolio of
risky assets, can be satisfied by single mutual fund
composed of that portfolio

The individual assets risk premium is a

If passive strategy is costless and efficient, why follow
function of its covariance with the market active strategy?
um of the market portfolio. At the point on the horizontal axis where ! # 1, we can read
the vertical axis the expected return on the market portfolio.
It is useful to compare the security market line to the capital market line. The CML
phs the risk premiums of efficient portfolios (i.e., portfolios composed of the market Confirming Pages
the risk-free asset) as a function of portfolio standard deviation. This is appropriate
Capital Asset Pricing Model - CAPM
ause standard deviation is a valid measure of risk for efficiently diversified portfo-
that are candidates for an investor’s overall portfolio. The SML, in contrast, graphs
Capital Asset Pricing Model - CAPM
ividual asset risk premiums as a function of asset 292 PART III Equilibrium in Capital Markets
. The relevant measure of risk for individual
ets held as parts of well-diversified portfolios is E(r)
the asset’s standard deviation or variance; it is, E(r) (%)
SML
ead, the contribution of the asset to the portfolio SML
iance, which we measure by the asset’s beta. The
L is valid for both efficient portfolios and indi-
ual assets. 17
Stock
α
The security market line provides a benchmark E(rM) 15.6

the evaluation of investment performance. Given 14

M

risk of an investment, as measured by its beta, the

L provides the required rate of return necessary E(rM) – rf = Slope of SML
compensate investors for risk as well as the time
ue of money. rf
Because the security market line is the graphic 1
6

resentation of the expected return–beta rela-

nship, “fairly priced” assets plot exactly on the
β
L; that is, their expected returns are commen- β
βM =1.0 1.0 1.2
ate with their risk. Given the assumptions we
de at the start of this section, all securities must Figure 9.3 The SML and a positive-alpha stock
on the SML in market equilibrium. Nevertheless, Figure 9.2 The security market line E[ri ] rf = ↵ i + i (E[rm ] rf )
see here how the CAPM may be of use in the
SML rf + (E[rm ] rf )
Alpha: Abnormal rate of return on security in excess of
in light of these shortcomings; it concludes that even given the anomalies cited, the
model still can be useful to managers who wish to increase the fundamental value of
that predicted by equilibrium model (CAPM)
their firms.

Example 9.1 Using the CAPM

Yet another use of the CAPM is in utility rate-making cases.9 In this case the issue is the
rate of return that a regulated utility should be allowed to earn on its investment in plant
dd 289 6/29/10 10:41 PM and equipment. Suppose that the equityholders have invested $100 million in the firm and

Capital Asset Pricing Model - CAPM Capital Asset Pricing Model - CAPM
that the beta of the equity is .6. If the T-bill rate is 6% and the market risk premium is
8%, then the fair profits to the firm would be assessed as 6 ! .6 " 8 # 10.8% of the
$100 million investment, or $10.8 million. The firm would be allowed to set prices at a
level expected to generate these profits.

9
This application is becoming less common, as many states are in the process of deregulating their public utilities
and allowing a far greater degree of free market pricing. Nevertheless, a considerable amount of rate setting still
takes place.

m =1 Normative - test the model

assumptions

N
X
Model
bod30700_ch09_280-317.indd 292 6/29/10 10:41 PM

p = wi ⇥ i Testing
i

Positive - test the model

predictions
Capital Asset Pricing Model - CAPM Capital Asset Pricing Model - CAPM

Predictions Tests

the market portfolio is not

The market portfolio is efficient observable

Asset alphas should be zero

therefore we cannot test it’s efficiency

Capital Asset Pricing Model - CAPM Capital Asset Pricing Model - CAPM

Usefulness
…the principles are still valid:

Useful predictor of expected returns

Investors should diversify
Systematic risk is the risk that matters
Well-diversified risky portfolio can be suitable for wide
range of investors
Capital Asset Pricing Model - CAPM Fama and French Models

Limitations Propose a multi-factor model that

better describe returns

Research shows that other factors affect returns E[ri ] rf = ↵ i + i (E[rm ] rf ) + HM L HM L + SM B SM B + ✏i

HML - High minus Low (value factor) - return of a portfolio of stocks

with a high book-to-market ratio minus the return of a portfolio of
stocks with a low book-to-maket ratio

which gave rise to multi-factor models SMB - Small minus Big (size factor) - return of a portfolio of small
stocks minus the return of a portfolio of big stocks

Fama and French Models

Usually results in:

APT
Higher adjusted R-square
Lower residual SD
Smaller value of alpha
Arbitrage pricing theory - APT Arbitrage pricing theory - APT

To ensure that there are not arbitrage

opportunities, any well diversified portfolio that
can be created:
• with no investment;
• and with no risk;

Ross (1976) should provide a zero expected return

Arbitrage pricing theory - APT Arbitrage pricing theory - APT

If any two portfolios are mispriced then

investors can sell the high-priced portfolio
and buy the low-priced portfolio

Excess returns of any well diversified

portfolios per unit of risk should be
the same In efficient markets these arbitrage
opportunities will rapidly disappear
Arbitrage pricing theory - APT Arbitrage pricing theory - APT

✦ applies to well diversified portfolios and not

necessarily to individual stocks

✦ does not rely on any assumption regarding the return ✦ returns can depend on multiple risk factors
distribution or about investors’ utility function (it only
assume that investors are risk averse and they prefer ✦ can be extended to a multi-period setting
more to less)

✦ does not rely on the market portfolio

APT vs CAPM

How investors behave in the two

models?