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Capital asset pricing model

An estimation oI the CAPM and the


Security Market Line (purple) Ior the
Dow Jones Industrial Average over the
last 3 years Ior monthly data.
From Wikipedia, the Iree encyclopedia
In Iinance, the capital asset pricing model (CAPM) is used to
determine a theoretically appropriate required rate oI return oI an asset,
iI that asset is to be added to an already well-diversiIied portIolio, given
that asset's non-diversiIiable risk. The model takes into account the
asset's sensitivity to non-diversiIiable risk (also known as systematic risk
or market risk), oIten represented by the quantity beta () in the
Iinancial industry, as well as the expected return oI the market and the
expected return oI a theoretical risk-Iree asset.
The model was introduced by Jack Treynor (1961, 1962),
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William
Sharpe (1964), John Lintner (1965a,b) and Jan Mossin (1966)
independently, building on the earlier work oI Harry Markowitz on
diversiIication and modern portIolio theory. Sharpe, Markowitz and
Merton Miller jointly received the Nobel Memorial Prize in Economics
Ior this contribution to the Iield oI Iinancial economics.
Contents
1 The Iormula
2 Security market line
3 Asset pricing
4 Asset-speciIic required return
5 Risk and diversiIication
6 The eIIicient Irontier
7 The market portIolio
8 Assumptions oI CAPM
9 Shortcomings oI CAPM
10 See also
11 ReIerences
12 Bibliography
13 External links
The formula
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The Security Market Line, seen here in a graph, describes a
relation between the beta and the asset's expected rate oI
return.
The CAPM is a model Ior pricing an individual security
or a portIolio. For individual securities, we make use oI
the security market line (SML) and its relation to
expected return and systematic risk (beta) to show how
the market must price individual securities in relation to
their security risk class. The SML enables us to calculate
the reward-to-risk ratio Ior any security in relation to
that oI the overall market. ThereIore, when the expected
rate oI return Ior any security is deIlated by its beta
coeIIicient, the reward-to-risk ratio Ior any individual
security in the market is equal to the market reward-
to-risk ratio, thus:
The market reward-to-risk ratio is eIIectively the market risk premium and by rearranging the above equation
and solving Ior E(Ri), we obtain the Capital Asset Pricing Model (CAPM).
where:
is the expected excess return on the capital asset
is the risk-Iree rate oI interest such as interest arising Irom government bonds
(the beta coefficient) is the sensitivity oI the expected excess asset returns to the expected excess
market returns, or also ,
is the expected excess return oI the market
is sometimes known as the market premium or risk premium (the diIIerence between the
expected market rate oI return and the risk-Iree rate oI return).
Restated, in terms oI risk premium, we Iind that:
which states that the individual risk premium equals the market premium times .
Note 1: the expected market rate oI return is usually estimated by measuring the Geometric Average oI the
historical returns on a market portIolio (i.e. S&P 500).
Note 2: the risk Iree rate oI return used Ior determining the risk premium is usually the arithmetic average oI
historical risk Iree rates oI return and not the current risk Iree rate oI return.
For the Iull derivation see Modern portIolio theory.
Security market line
The SML essentially graphs the results Irom the capital asset pricing model (CAPM) Iormula. The x-axis
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represents the risk (beta), and the v-axis represents the expected return. The market risk premium is determined
Irom the slope oI the SML.
The relationship between and required return is plotted on the securities market line (SML) which shows
expected return as a Iunction oI . The intercept is the nominal risk-Iree rate available Ior the market, while the
slope is E(R
m
R
f
). The securities market line can be regarded as representing a single-Iactor model oI the asset
price, where Beta is exposure to changes in value oI the Market. The equation oI the SML is thus:
It is a useIul tool in determining iI an asset being considered Ior a portIolio oIIers a reasonable expected return
Ior risk. Individual securities are plotted on the SML graph. II the security's risk versus expected return is
plotted above the SML, it is undervalued since the investor can expect a greater return Ior the inherent risk. And
a security plotted below the SML is overvalued since the investor would be accepting less return Ior the amount
oI risk assumed.
Asset pricing
Once the expected/required rate oI return, E(R
i
), is calculated using CAPM, we can compare this required rate
oI return to the asset's estimated rate oI return over a speciIic investment horizon to determine whether it would
be an appropriate investment. To make this comparison, you need an independent estimate oI the return outlook
Ior the security based on either fundamental or technical analysis techniques, including P/E, M/B etc.
In theory, thereIore, an asset is correctly priced when its estimated price is the same as the required rates oI
return calculated using the CAPM. II the estimate price is higher than the CAPM valuation, then the asset is
undervalued (and overvalued when the estimated price is below the CAPM valuation).
Asset-specific required return
The CAPM returns the asset-appropriate required return or discount rate - i.e. the rate at which Iuture cash
Ilows produced by the asset should be discounted given that asset's relative riskiness. Betas exceeding one
signiIy more than average "riskiness"; betas below one indicate lower than average. Thus a more risky stock will
have a higher beta and will be discounted at a higher rate; less sensitive stocks will have lower betas and be
discounted at a lower rate. Given the accepted concave utility Iunction, the CAPM is consistent with intuition -
investors (should) require a higher return Ior holding a more risky asset.
Since beta reIlects asset-speciIic sensitivity to non-diversiIiable, i.e. market risk, the market as a whole, by
deIinition, has a beta oI one. Stock market indices are Irequently used as local proxies Ior the market - and in
that case (by deIinition) have a beta oI one. An investor in a large, diversiIied portIolio (such as a mutual Iund)
thereIore expects perIormance in line with the market.
Risk and diversification
The risk oI a portIolio comprises systematic risk, also known as undiversiIiable risk, and unsystematic risk which
is also known as idiosyncratic risk or diversiIiable risk. Systematic risk reIers to the risk common to all securities
- i.e. market risk. Unsystematic risk is the risk associated with individual assets. Unsystematic risk can be
diversiIied away to smaller levels by including a greater number oI assets in the portIolio (speciIic risks "average
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The (Markowitz) eIIicient Irontier. CAL stands Ior the capital allocation line.
out"). The same is not possible Ior systematic risk within one market. Depending on the market, a portIolio oI
approximately 30-40 securities in developed markets such as UK or US will render the portIolio suIIiciently
diversiIied such that risk exposure is limited to systematic risk only. In developing markets a larger number is
required, due to the higher asset volatilities.
A rational investor should not take on any diversiIiable risk, as only non-diversiIiable risks are rewarded within
the scope oI this model. ThereIore, the required return on an asset, that is, the return that compensates Ior risk
taken, must be linked to its riskiness in a portIolio context - i.e. its contribution to overall portIolio riskiness - as
opposed to its "stand alone riskiness." In the CAPM context, portIolio risk is represented by higher variance i.e.
less predictability. In other words the beta oI the portIolio is the deIining Iactor in rewarding the systematic
exposure taken by an investor.
The efficient frontier
Main article. Efficient frontier
The CAPM assumes that the
risk-return proIile oI a portIolio can be
optimized - an optimal portIolio
displays the lowest possible level oI
risk Ior its level oI return. Additionally,
since each additional asset introduced
into a portIolio Iurther diversiIies the
portIolio, the optimal portIolio must
comprise every asset, (assuming no
trading costs) with each asset value-
weighted to achieve the above
(assuming that any asset is inIinitely
divisible). All such optimal portIolios,
i.e., one Ior each level oI return,
comprise the eIIicient Irontier.
Because the unsystematic risk is diversiIiable, the total risk oI a portIolio can be viewed as beta.
The market portfolio
An investor might choose to invest a proportion oI his or her wealth in a portIolio oI risky assets with the
remainder in cash - earning interest at the risk Iree rate (or indeed may borrow money to Iund his or her
purchase oI risky assets in which case there is a negative cash weighting). Here, the ratio oI risky assets to risk
Iree asset does not determine overall return - this relationship is clearly linear. It is thus possible to achieve a
particular return in one oI two ways:
By investing all oI one's wealth in a risky portIolio, 1.
or by investing a proportion in a risky portIolio and the remainder in cash (either borrowed or invested). 2.
For a given level oI return, however, only one oI these portIolios will be optimal (in the sense oI lowest risk).
Since the risk Iree asset is, by deIinition, uncorrelated with any other asset, option 2 will generally have the
lower variance and hence be the more eIIicient oI the two.
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This relationship also holds Ior portIolios along the eIIicient Irontier: a higher return portIolio plus cash is more
eIIicient than a lower return portIolio alone Ior that lower level oI return. For a given risk Iree rate, there is only
one optimal portIolio which can be combined with cash to achieve the lowest level oI risk Ior any possible
return. This is the market portIolio.
Assumptions of CAPM
All investors:
Aim to maximize economic utility. 1.
Are rational and risk-averse. 2.
Are broadly diversiIied across a range oI investments. 3.
Are price takers, i.e., they cannot inIluence prices. 4.
Can lend and borrow unlimited under the risk Iree rate oI interest. 5.
Trade without transaction or taxation costs. 6.
Deal with securities that are all highly divisible into small parcels. 7.
Assume all inIormation is at the same time available to all investors. 8.
PerIect Competitive Markets 9.
Shortcomings of CAPM
The model assumes that either asset returns are (jointly) normally distributed random variables or that
investors employ a quadratic Iorm oI utility. It is however Irequently observed that returns in equity and
other markets are not normally distributed. As a result, large swings (3 to 6 standard deviations Irom the
mean) occur in the market more Irequently than the normal distribution assumption would expect.
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The model assumes that the variance oI returns is an adequate measurement oI risk. This might be
justiIied under the assumption oI normally distributed returns, but Ior general return distributions other
risk measures (like coherent risk measures) will likely reIlect the investors' preIerences more adequately.
Indeed risk in Iinancial investments is not variance in itselI, rather it is the probability oI losing: it is
asymmetric in nature.
The model assumes that all investors have access to the same inIormation and agree about the risk and
expected return oI all assets (homogeneous expectations assumption).
|citation needed|
The model assumes that the probability belieIs oI investors match the true distribution oI returns. A
diIIerent possibility is that investors' expectations are biased, causing market prices to be inIormationally
ineIIicient. This possibility is studied in the Iield oI behavioral Iinance, which uses psychological
assumptions to provide alternatives to the CAPM such as the overconIidence-based asset pricing model oI
Kent Daniel, David HirshleiIer, and Avanidhar Subrahmanyam (2001)
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.
The model does not appear to adequately explain the variation in stock returns. Empirical studies show
that low beta stocks may oIIer higher returns than the model would predict. Some data to this eIIect was
presented as early as a 1969 conIerence in BuIIalo, New York in a paper by Fischer Black, Michael
Jensen, and Myron Scholes. Either that Iact is itselI rational (which saves the eIIicient-market hypothesis
but makes CAPM wrong), or it is irrational (which saves CAPM, but makes the EMH wrong indeed, this
possibility makes volatility arbitrage a strategy Ior reliably beating the market).
|citation needed|
The model assumes that given a certain expected return investors will preIer lower risk (lower variance)
to higher risk and conversely given a certain level oI risk will preIer higher returns to lower ones. It does
not allow Ior investors who will accept lower returns Ior higher risk. Casino gamblers clearly pay Ior risk,
and it is possible that some stock traders will pay Ior risk as well.
|citation needed|
The model assumes that there are no taxes or transaction costs, although this assumption may be relaxed
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with more complicated versions oI the model.
|citation needed|
The market portIolio consists oI all assets in all markets, where each asset is weighted by its market
capitalization. This assumes no preIerence between markets and assets Ior individual investors, and that
investors choose assets solely as a Iunction oI their risk-return proIile. It also assumes that all assets are
inIinitely divisible as to the amount which may be held or transacted.
|citation needed|
The market portIolio should in theory include all types oI assets that are held by anyone as an investment
(including works oI art, real estate, human capital...) In practice, such a market portIolio is unobservable
and people usually substitute a stock index as a proxy Ior the true market portIolio. UnIortunately, it has
been shown that this substitution is not innocuous and can lead to Ialse inIerences as to the validity oI the
CAPM, and it has been said that due to the inobservability oI the true market portIolio, the CAPM might
not be empirically testable. This was presented in greater depth in a paper by Richard Roll in 1977, and is
generally reIerred to as Roll's critique.
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The model assumes just two dates, so that there is no opportunity to consume and rebalance portIolios
repeatedly over time. The basic insights oI the model are extended and generalized in the intertemporal
CAPM (ICAPM) oI Robert Merton, and the consumption CAPM (CCAPM) oI Douglas Breeden and
Mark Rubinstein.
|citation needed|
CAPM assumes that all investors will consider all oI their assets and optimize one portIolio. This is in
sharp contradiction with portIolios that are held by investors: humans tend to have Iragmented portIolios
(or rather multiple portIolios: Ior each goal one portIolio - see behavioural portIolio theory
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and
Maslowian PortIolio Theory
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.
See also
Arbitrage pricing theory (APT)
Consumption beta (C-CAPM)
EIIicient market hypothesis
Fama-French three-Iactor model
Hamada's equation
Modern portIolio theory
Roll's critique
Valuation (Iinance)
References
^ http://ssrn.com/abstract447580 1.
^ Mandelbrot, B., and Hudson, R. L. (2004). The (Mis)Behaviour oI Markets: A Fractal View oI Risk, Ruin, and
Reward. London: ProIile Books.
2.
^ 'OverconIidence, Arbitrage, and Equilibrium Asset Pricing,' Kent D. Daniel, David HirshleiIer and Avanidhar
Subrahmanyam, Journal oI Finance, 56(3) (June, 2001), pp. 921-965
3.
^ 'ROLL, R. (1977): 'A Critique oI the Asset Pricing Theory`s Tests, Journal oI Financial Economics, 4, 129176. 4.
^ SHEFRIN, H., AND M. STATMAN (2000): 'Behavioral PortIolio Theory, Journal oI Financial and Quantitative
Analysis, 35(2), 127151.
5.
^ DE BROUWER, Ph. (2009): 'Maslowian PortIolio Theory: An alternative Iormulation oI the Behavioural
PortIolio Theory, Journal oI Asset Management, 9 (6), pp. 359365.
6.
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Bibliography
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Fama, Eugene F. (1968). Risk, Return and Equilibrium. Some Clarifving Comments. Journal oI Finance
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Issues, Journal oI Finance, 32 (177)
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25
Treynor, Jack L. (1961). Market Jalue, Time, and Risk. Unpublished manuscript.
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External links
Two asset eIIicient Irontier (http://www.duke.edu/~charvey/twoasset/index.html)
Multiasset eIIicient Irontier (http://www.duke.edu/~charvey/Irontier/Irontier.html)
Retrieved Irom "http://en.wikipedia.org/wiki/Capitalassetpricingmodel"
Categories: Finance theories , Mathematical Iinance , Financial markets , PortIolio theories
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