Asset Pricing Models

Chapter 9
Charles P. Jones, Investments: Analysis and
Management,
Tenth Edition, John Wiley & Sons
Prepared by
G.D. Koppenhaver, Iowa State University

9-1

Capital Asset Pricing Model

Focus on the equilibrium relationship

between the risk and expected return
on risky assets
Builds on Markowitz portfolio theory
Each investor is assumed to diversify
his or her portfolio according to the
Markowitz model

9-2

CAPM Assumptions

All investors:

Use the same

information to
generate an efficient
frontier
Have the same oneperiod time horizon
Can borrow or lend
money at the risk-free
rate of return

No transaction costs,
no personal income
taxes, no inflation
No single investor
can affect the price
of a stock
Capital markets are
in equilibrium

9-3

Borrowing and Lending Possibilities

Risk free assets

Certain-to-be-earned expected return and a

variance of return of zero
No correlation with risky assets
Usually proxied by a Treasury security

Amount to be received at maturity is free of

default risk, known with certainty

Adding a risk-free asset extends and

changes the efficient frontier
9-4

Risk-Free Lending
Riskless assets can
be combined with
L
any portfolio in the
B
efficient set AB

E(R)

T
Z

RF
A

Z implies lending

Set of portfolios on
line RF to T
dominates all
portfolios below it

Risk
9-5

Impact of Risk-Free Lending

If wRF placed in a risk-free asset

Expected portfolio return

E(R p ) w RF RF ( 1-w RF )E(R X )

Risk of the portfolio

p ( 1-w RF ) X

Expected return and risk of the

portfolio with lending is a weighted
average
9-6

Borrowing Possibilities

Investor no longer restricted to own

wealth
Interest paid on borrowed money

Higher returns sought to cover expense

Assume borrowing at RF

Risk will increase as the amount of

borrowing increases

Financial leverage
9-7

The New Efficient Set

Risk-free investing and borrowing

creates a new set of expected returnrisk possibilities
Addition of risk-free asset results in

A change in the efficient set from an arc to

a straight line tangent to the feasible set
without the riskless asset
Chosen portfolio depends on investors riskreturn preferences
9-8

Portfolio Choice

The more conservative the investor the

more is placed in risk-free lending and
the less borrowing
The more aggressive the investor the
less is placed in risk-free lending and
the more borrowing

Most aggressive investors would use

leverage to invest more in portfolio T

9-9

Market Portfolio

Most important implication of the CAPM

All investors hold the same optimal portfolio

of risky assets
The optimal portfolio is at the highest point
of tangency between RF and the efficient
frontier
The portfolio of all risky assets is the
optimal risky portfolio

Called the market portfolio

9-10

Characteristics of the Market

Portfolio

All risky assets must be in portfolio, so

it is completely diversified

Includes only systematic risk

All securities included in proportion to

their market value
Unobservable but proxied by S&P 500
Contains worldwide assets

Financial and real assets

9-11

Capital Market Line

L
M

E(RM)

x
RF

y
M
Risk

Line from RF to L is
capital market line
(CML)
x = risk premium
=E(RM) - RF
y =risk =M
Slope =x/y
=[E(RM) - RF]/M
y-intercept = RF
9-12

The Separation Theorem

Investors use their preferences

(reflected in an indifference curve) to
determine their optimal portfolio
Separation Theorem:

The investment decision, which risky

portfolio to hold, is separate from the
financing decision
Allocation between risk-free asset and risky
portfolio separate from choice of risky
portfolio, T
9-13

Separation Theorem

All investors

Invest in the same portfolio

Attain any point on the straight line RF-T-L
by by either borrowing or lending at the
rate RF, depending on their preferences

Risky portfolios are not tailored to each

individuals taste

9-14

Capital Market Line

Slope of the CML is the market price of

risk for efficient portfolios, or the
equilibrium price of risk in the market
Relationship between risk and expected
return for portfolio P (Equation for
CML):

E(RM ) RF
E(R p ) RF
p
M
9-15

Security Market Line

CML Equation only applies to markets

in equilibrium and efficient portfolios
The Security Market Line depicts the
tradeoff between risk and expected
return for individual securities
Under CAPM, all investors hold the
market portfolio

How does an individual security contribute

to the risk of the market portfolio?
9-16

Security Market Line

A securitys contribution to the risk of

the market portfolio is based on beta
Equation for expected return for an
individual stock

E(Ri ) RF i E(RM ) RF

9-17

Security Market Line

SM
L

E(R)
kM

kRF

Beta = 1.0 implies

as risky as market
Securities A and B
are more risky than
the market

Beta >1.0

Security C is less
risky than the
0.5 1.0 1.5 2.0 market

BetaM

Beta <1.0

9-18

Security Market Line

Beta measures systematic risk

Measures relative risk compared to the

market portfolio of all stocks
Volatility different than market

All securities should lie on the SML

The expected return on the security should

be only that return needed to compensate
for systematic risk

9-19

CAPMs Expected
Return-Beta Relationship

Required rate of return on an asset (ki)

is composed of

risk-free rate (RF)

risk premium (i [ E(RM) - RF ])

Market risk premium adjusted for specific security

ki = RF +i [ E(RM) - RF ]

The greater the systematic risk, the greater

the required return

9-20

Estimating the SML

Treasury Bill rate used to estimate RF

Expected market return unobservable

Estimated using past market returns and

taking an expected value

Estimating individual security betas

difficult

Only company-specific factor in CAPM

Requires asset-specific forecast
9-21

Estimating Beta

Market model

Relates the return on each stock to the

return on the market, assuming a linear
relationship
Ri = i + i RM +ei

Characteristic line

Line fit to total returns for a security

relative to total returns for the market
index
9-22

How Accurate Are Beta

Estimates?

Betas change with a companys

situation

Estimating a future beta

Not stationary over time

May differ from the historical beta

RM represents the total of all

marketable assets in the economy

Approximated with a stock market index

Approximates return on all common stocks
9-23

How Accurate Are Beta

Estimates?

No one correct number of observations

and time periods for calculating beta
The regression calculations of the true
and from the characteristic line are
subject to estimation error
Portfolio betas more reliable than
individual security betas

9-24

Arbitrage Pricing Theory

Based on the Law of One Price

Two otherwise identical assets cannot sell at

different prices
Equilibrium prices adjust to eliminate all
arbitrage opportunities

Unlike CAPM, APT does not assume

single-period investment horizon, absence

of personal taxes, riskless borrowing or
lending, mean-variance decisions

9-25

Factors

APT assumes returns generated by a

factor model
Factor Characteristics

Each risk must have a pervasive influence

on stock returns
Risk factors must influence expected return
and have nonzero prices
Risk factors must be unpredictable to the
market
9-26

APT Model

Most important are the deviations of

the factors from their expected values
The expected return-risk relationship
for the APT can be described as:
E(Ri) =RF +bi1 (risk premium for
factor 1) +bi2 (risk premium for
factor 2) + +bin (risk premium
for factor n)
9-27

Problems with APT

Factors are not well specified ex ante

To implement the APT model, need the

factors that account for the differences
among security returns

CAPM identifies market portfolio as single factor

Neither CAPM or APT has been proven

superior

Both rely on unobservable expectations

9-28

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9-29