CAPM and the Characteristic

Line

The Characteristic Line

Total risk of any asset can be assessed by

measuring variability of its returns

Total risk can be divided into two parts
diversifiable risk (unsystematic risk) and nondiversifiable risk (systematic risk)
The characteristic line is used to measure
statistically the undiversifiable risk and
diversifiable risk of individual assets and
portfolios

Characteristic line for the ith asset is:

ri,t = ai + birm,t + ei,t OR
ri,t = birm,t + ai + ei,t
Take Variance of both sides of Equation
VAR (ri,t) = VAR(birm,t ) +VAR(ai) + VAR(ei,t)
VAR(birm,t ) = VAR (ri,t) - VAR(ei,t) OR
VAR(ei,t) = VAR(ri,t) - VAR(birm,t )

Beta Coefficients
An index of risk
Measures the volatility of a stock (or

portfolio) relative to the market

Beta Coefficients Combine

The variability of the assets return
The variability of the market return
The correlation between

the stock's return and

the market return

Beta Coefficients
Beta coefficients are the slope of

the regression line relating

the return on the market (the
independent variable) to
the return on the stock (the
dependent variable)

Beta Coefficients

Interpretation of the
Numerical Value of Beta
Beta = 1.0 Stock's return has

same volatility as the market return

Beta > 1.0 Stock's return is more

volatile than the market return

Interpretation of the
Numerical Value of Beta

Interpretation of the Numerical

Value of Beta
Beta < 1.0 Stock's return is less

volatile than the market return

Interpretation of the Numerical

Value of Beta

High Beta Stocks

More systematic market risk
May be appropriate for high-risk

tolerant (aggressive) investors

Low Beta Stocks

Less systematic market risk
May be appropriate for low-risk

tolerant (defensive) investors

Individual Stock Betas

May change over time
Tendency to move toward 1.0, the

market beta

Portfolio Betas
Weighted average of the individual

asset's betas
May be more stable than

individual stock betas

How Characteristic Line leads

to CAPM?
The characteristic regression line of an

asset explains the assets systematic

variability of returns in terms of market
forces that affect all assets simultaneously
The portion of total risk not explained by
characteristic line is called unsystematic
risk

Assets with high degrees systematic

risk must be priced to yield high

returns in order to induce investors to
accept high degrees of risk that are
undivesifiable in the market
CAPM illustrates positive relationship
between systematic risk and return on
an asset

Capital Asset Pricing Model

(CAPM)
For a very well-diversified portfolio, beta

is the correct measure of a securitys risk.

All investments and portfolios of
investments must lie along a straight-line
in the return-beta space
Required return on any asset is a linear
function of the systematic risk of that asset
E(ri) = rf + [E(rm) rf] i

The Capital Asset Pricing

Model (CAPM)
The CAPM has

A macro component explains risk

and return in a portfolio context
A micro component explains
individual stock returns
The micro component is also used
to value stocks

Beta Coefficients and

The Security Market Line
The return on a stock depends on

the risk free rate (rf)

the return on the market (rm)
the stock's beta
the return on a stock:
k= rf + (rm - rf)beta

Beta Coefficients and

The Security Market Line
The figure relating systematic risk

(beta) and the return on a stock

Beta Coefficients and

The Security Market Line

CAPM can be used to price any asset provided

we know the systematic risk of that asset

In equilibrium, every asset must be priced so
that its risk-adjusted required rate of return
falls exactly on the straight line
If an investment were to lie above or below
that straight line, then an opportunity for
riskless arbitrage would exist.

Examples of CAPM
Stocks
Expected Return
Beta
A
16%
1.2
B
19%
1.3
C
13%
0.75
E(rm) = 18% rf = 14%
Which of these stocks is correctly priced?

Example of CAPM
Given the following security market line

E(ri) = 0.07 + 0.09I

What must be the returns for two stocks
assuming their betas are 1.2 and 0.9?