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Investments, 8

th
edition
Bodie, Kane and Marcus
Slides by Susan Hine
McGraw-Hill/Irwin
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
CHAPTER 9
The Capital Asset
Pricing Model
9-2
It is the equilibrium model that underlies all
modern financial theory
Derived using principles of diversification with
simplified assumptions
Markowitz, Sharpe, Lintner and Mossin are
researchers credited with its development
Capital Asset Pricing Model (CAPM)
9-3
Individual investors are price takers
Single-period investment horizon
Investments are limited to traded financial
assets
No taxes and transaction costs
Assumptions
9-4
Information is costless and available to all
investors
Investors are rational mean-variance
optimizers
There are homogeneous expectations
Assumptions Continued
9-5
All investors will hold the same portfolio for
risky assets market portfolio
Market portfolio contains all securities and
the proportion of each security is its market
value as a percentage of total market value
Resulting Equilibrium Conditions
9-6
Risk premium on the market depends on the
average risk aversion of all market
participants
Risk premium on an individual security is a
function of its covariance with the market
Resulting Equilibrium Conditions
Continued
9-7
Figure 9.1 The Efficient Frontier and the
Capital Market Line
9-8
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:


2
2
( )
where is the variance of the market portolio and
is the average degree of risk aversion across investors
M f M
M
E r r A
A
o
o
=
9-9
The risk premium on individual securities is a
function of the individual securitys
contribution to the risk of the market portfolio
An individual securitys risk premium is a
function of the covariance of returns with the
assets that make up the market portfolio
Return and Risk For Individual Securities
9-10
Using GE Text Example
Covariance of GE return with the market
portfolio:


Therefore, the reward-to-risk ratio for
investments in GE would be:

1 1
( , ) , ( , )
n n
GE M GE k k k k GE
k k
Cov r r Cov r w r w Cov r r
= =
| |
= =
|
\ .

( )
( )
GE's contribution to risk premium
GE's contribution to variance ( , ) ( , )
GE GE f
GE f
GE GE M GE M
w E r r
E r r
w Cov r r Cov r r
(


= =
9-11
Using GE Text Example Continued
Reward-to-risk ratio for investment in
market portfolio:


Reward-to-risk ratios of GE and the market
portfolio:

And the risk premium for GE:
2
( )
Market risk premium
Market variance
M f
M
E r r
o

=
2
( ) ( ( )
( , )
GE f M f
GE M M
E r r E r r
Cov r r o

=
2
( , )
( ) ( )
GE M
GE f M f
M
Cov r r
E r r E r r
o
(
=

9-12
Expected Return-Beta Relationship
CAPM holds for the overall portfolio because:



This also holds for the market portfolio:
P
( ) ( ) and
P k k
k
k k
k
E r w E r
w | |
=
=

( ) ( )
M f M M f
E r r E r r |
(
= +

9-13
Figure 9.2 The Security Market Line
9-14
Figure 9.3 The SML and a Positive-
Alpha Stock
9-15
The Index Model and Realized Returns
To move from expected to realized returns
use the index model in excess return form:


The index model beta coefficient turns out to
be the same beta as that of the CAPM
expected return-beta relationship
i i i M i
R R e o | = + +
9-16
Figure 9.4 Estimates of Individual Mutual
Fund Alphas, 1972-1991
9-17
The CAPM and Reality
Is the condition of zero alphas for all stocks
as implied by the CAPM met
Not perfect but one of the best available
Is the CAPM testable
Proxies must be used for the market
portfolio
CAPM is still considered the best available
description of security pricing and is widely
accepted
9-18
Econometrics and the Expected Return-
Beta Relationship
It is important to consider the econometric
technique used for the model estimated
Statistical bias is easily introduced
Miller and Scholes paper demonstrated
how econometric problems could lead one
to reject the CAPM even if it were perfectly
valid
9-19
Extensions of the CAPM
Zero-Beta Model
Helps to explain positive alphas on low
beta stocks and negative alphas on high
beta stocks
Consideration of labor income and non-
traded assets
Mertons Multiperiod Model and hedge
portfolios
Incorporation of the effects of changes in
the real rate of interest and inflation
9-20
Extensions of the CAPM Continued
A consumption-based CAPM
Models by Rubinstein, Lucas, and Breeden
Investor must allocate current wealth between
todays consumption and investment for the future
9-21
Liquidity and the CAPM
Liquidity
Illiquidity Premium
Research supports a premium for illiquidity.
Amihud and Mendelson
Acharya and Pedersen
9-22
Figure 9.5 The Relationship Between
Illiquidity and Average Returns
9-23
Three Elements of Liquidity
Sensitivity of securitys illiquidity to market
illiquidity:

Sensitivity of stocks return to market
illiquidity:

Sensitivity of the security illiquidity to the
market rate of return:

1
( , )
( )
i M
L
M M
Cov C C
Var R C
| =

3
( , )
( )
i M
L
M M
Cov C R
Var R C
| =

2
( , )
( )
i M
L
M M
Cov R C
Var R C
| =