CAPM

CAPITAL ASSET PRICING MODEL
(CAPM)
Stand-Alone Risk
Portfolio Risk
Risk and Return: CAPM/SML
8-1
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What is investment risk?
• Two types of investment risk

– Stand-alone risk
– Portfolio risk
• Investment risk is related to the probability of
earning a low or negative actual return.
• The greater the chance of lower than expected, or
negative returns, the riskier the investment.
8-2
Breaking Down Sources of Risk
Stand-alone risk = Market risk + Diversifiable risk
• Market risk: portion of a security’s stand-alone risk

that cannot be eliminated through diversification.
Measured by beta.
• Diversifiable risk: portion of a security’s stand-
alone risk that can be eliminated through proper
diversification.
8-3
Capital Asset Pricing Model (CAPM)
• Model linking risk and required returns. CAPM

suggests that there is a Security Market Line (SML)
that states that a stock’s required return equals the
risk-free return plus a risk premium that reflects the
stock’s risk after diversification.
ri = rRF + (rM – rRF)bi
• Primary conclusion: The relevant riskiness of a stock
is its contribution to the riskiness of a well-diversified
portfolio.
• In other words, diversification is the key!
8-4
Beta
• Measures a stock’s market risk, and shows a stock’s

volatility relative to the market.
• Indicates how risky a stock is if the stock is held in a
well-diversified portfolio.
8-5
Comments on Beta
• If beta = 1.0, the security is just as risky as the

average stock.
• If beta > 1.0, the security is riskier than average.
• If beta < 1.0, the security is less risky than average.
• Most stocks have betas in the range of 0.5 to 1.5.
8-6
Can the beta of a security be negative?
• Yes, if the correlation between Stock i and the

market is negative (i.e., ρi,m < 0).
• If the correlation is negative, the regression line
would slope downward, and the beta would be
negative.
• However, a negative beta is highly unlikely.
8-7
Calculating Betas
• Well-diversified investors are primarily concerned

with how a stock is expected to move relative to the
market in the future.
• Without a crystal ball to predict the future, analysts
are forced to rely on historical data. A typical
approach to estimate beta is to run a regression of
the security’s past returns against the past returns
of the market.
• The slope of the regression line is defined as the
beta coefficient for the security.
8-8
Illustrating the Calculation of Beta
_
ri
.
.
20 Year rM ri
1 15% 18%
15
2 -5 -10
10 3 12 16
5
-5 0 5 10 15 20
rM
Regression line:
.
-5
^
ri = -2.59 + 1.44 ^rM
-10
8-9
Beta Coefficients for High Tech, Collections, and
T-Bills
ri HT: b = 1.32
40
20
T-bills: b = 0
-20 0 20 40
rM
Coll: b = -0.87
-20
8-10
Comparing Expected Returns and Beta Coefficients
Security Expected Return Beta

High Tech 12.4% 1.32
Market 10.5 1.00
US Rubber 9.8 0.88
T-Bills 5.5 0.00
Collections 1.0 -0.87
Riskier securities have higher returns, so the rank order
is OK.
8-11
The Security Market Line (SML): Calculating
Required Rates of Return
SML: ri = rRF + (rM – rRF)bi

ri = rRF + (RPM)bi
• Assume the yield curve is flat and that rRF = 5.5%

and
RPM = rM  rRF = 10.5%  5.5% = 5.0%.
8-12
What is the market risk premium?
• Additional return over the risk-free rate needed to

compensate investors for assuming an average
amount of risk.
• Its size depends on the perceived risk of the stock
market and investors’ degree of risk aversion.
• Varies from year to year, but most estimates
suggest that it ranges between 4% and 8% per year.
8-13
Calculating Required Rates of Return
rHT = 5.5% + (5.0%)(1.32)

= 5.5% + 6.6% = 12.10%
rM = 5.5% + (5.0%)(1.00) = 10.50%
rUSR = 5.5% +(5.0%)(0.88) = 9.90%
rT-bill = 5.5% + (5.0)(0.00) = 5.50%
rColl = 5.5% + (5.0%)(-0.87) = 1.15%
8-14
Expected vs. Required Returns
(We require this return, but the expected is…)
r̂ r
High Tech 12.4% 12.1% Undervalued (r̂  r)
Market 10.5 10.5 Fairly valued (r̂  r)
US Rubber 9.8 9.9 Overvalued (r̂  r)
T-bills 5.5 5.5 Fairly valued (r̂  r)
Collections 1.0 1.15 Overvalued (r̂  r)
8-15
Illustrating the Security Market Line
SML: ri = 5.5% + (5.0%)bi

ri (%)
SML
. HT
rM = 10.5
..
rRF = 5.5 .T-bills USR
-1 Coll
. 0 1 2
Risk, bi
8-16
An Example:
Equally-Weighted Two-Stock Portfolio
• Create a portfolio with 50% invested in High Tech

and 50% invested in Collections.
• The beta of a portfolio is the weighted average of
each of the stock’s betas.
bP = wHTbHT + wCollbColl
bP = 0.5(1.32) + 0.5(-0.87)
bP = 0.225
8-17
Calculating Portfolio Required Returns
• The required return of a portfolio is the weighted

average of each of the stock’s required returns.
rP = wHTrHT + wCollrColl
rP = 0.5(12.10%) + 0.5(1.15%)
rP = 6.625%
• Or, using the portfolio’s beta, CAPM can be used to
solve for expected return.
rP = rRF + (RPM)bP
rP = 5.5% + (5.0%)(0.225)
rP = 6.625%
8-18
Factors That Change the SML
• What if investors raise inflation expectations by 3%,

what would happen to the SML?
ri (%)
ΔI = 3% SML2
13.5 SML1
10.5
8.5
5.5
Risk, bi
0 0.5 1.0 1.5
8-19
Factors That Change the SML
• What if investors’ risk aversion increased, causing

the market risk premium to increase by 3%, what
would happen to the SML?
ri (%) SML2
ΔRPM = 3%
13.5 SML1
10.5
5.5
Risk, bi
0 0.5 1.0 1.5 8-20
Verifying the CAPM Empirically
• The CAPM has not been verified completely.

• Statistical tests have problems that make
verification almost impossible.
• Some argue that there are additional risk factors,
other than the market risk premium, that must be
considered.
8-21
More Thoughts on the CAPM
• Investors seem to be concerned with both market

risk and total risk. Therefore, the SML may not
produce a correct estimate of ri.
ri = rRF + (rM – rRF)bi + ???
• CAPM/SML concepts are based upon expectations,
but betas are calculated using historical data. A
company’s historical data may not reflect investors’
expectations about future riskiness.
8-22

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CAPITAL ASSET PRICING MODEL

• Two types of investment risk

Stand-alone risk = Market risk + Diversifiable risk

• Market risk: portion of a security’s stand-alone risk

• Model linking risk and required returns. CAPM

• Measures a stock’s market risk, and shows a stock’s

• If beta = 1.0, the security is just as risky as the

• Yes, if the correlation between Stock i and the

• Well-diversified investors are primarily concerned

Security Expected Return Beta

SML: ri = rRF + (rM – rRF)bi

• Assume the yield curve is flat and that rRF = 5.5%

• Additional return over the risk-free rate needed to

rHT = 5.5% + (5.0%)(1.32)

SML: ri = 5.5% + (5.0%)bi

• Create a portfolio with 50% invested in High Tech

• The required return of a portfolio is the weighted

• What if investors raise inflation expectations by 3%,

• What if investors’ risk aversion increased, causing

• The CAPM has not been verified completely.

• Investors seem to be concerned with both market

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