Asset Pricing

Chapter 9
Charles P. Jones, Investments: Principles and Concepts,
Eleventh Edition, John Wiley & Sons


Capital Asset Pricing
 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


CAPM Assumptions
 All investors:
◦ Use the same
information to
generate an efficient  No transaction costs,
no personal income
◦ Have the same one-
period time horizon
taxes, no inflation
◦ Can borrow or lend  No single investor
money at the risk-free can affect the price
rate of return of a stock
 Capital markets are
in equilibrium

known with certainty  Adding a risk-free asset extends and changes the efficient frontier 9- 4 .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.

Risk-Free Lending L Riskless assets can be combined with B any portfolio in the E(R) T efficient set AB Z X ◦ Z implies lending RF  Set of portfolios on A 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 σ p  ( 1-w RF )σ 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 return-risk 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 investor’s risk-return 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 .

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 .Characteristics of the Market Portfolio  All risky assets must be in portfolio.

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

T 9- 13 .The Separation Theorem  Investors use their preferences (reflected in an indifference curve) to determine their optimal portfolio  Separation Theorem: ◦ The investment decision. is separate from the financing decision ◦ Allocation between risk-free asset and risky portfolio separate from choice of risky portfolio. which risky portfolio to hold.

depending on their preferences  Risky portfolios are not tailored to each individual’s taste 9- 14 .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.

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  σp σM 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 security’s contribution to the risk of the market portfolio is based on beta  Equation for expected return for an individual stock E(Ri )  RF  βi  E(RM )  RF  9- 17 .

Security Market Line SM E(R) L  Beta = 1.0 implies as risky as market A kM B  Securities A and B are more risky than C kRF the market ◦ Beta >1.0 Security C is less  0 0.0 risky than the BetaM market ◦ Beta <1.5 2.0 1.0 9-18 .5 1.

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 .

CAPM’s 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 ] ◦ The greater the systematic risk.RF ])  Market risk premium adjusted for specific security ki = RF +i [ E(RM) . 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 .

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 .Estimating Beta  Market model ◦ Relates the return on each stock to the return on the market.

How Accurate Are Beta Estimates?  Betas change with a company’s situation ◦ Not stationary over time  Estimating a future beta ◦ 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 .

absence of personal taxes. riskless borrowing or lending.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. mean-variance decisions 9- 25 . APT does not assume ◦ single-period investment horizon.

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 .

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 .Problems with APT  Factors are not well specified ex ante ◦ To implement the APT model.

Coeficient Beta : Contoh i = Cov(rirM 1) / M² Expected Return : E(ri)= RF + i [E(rM).648 % C 15 Cov (rCrM) 1.215 % D 16 Cov (rDrM) 0.RF]  = Ri – E(r) Sto Return Covariance antara ck Realisasi Saham i dgn index pasar A 17 Cov (rArM) 0.972 % B 14 Cov (rBrM) 0.6075 % .

000 1) Beta saham () 0.2 1.8 1.000 Rp 1. B dan C adalah sebagai berikut : Saham A Saham B Saham C Harga periode Rp 1.400 sekarang (Pt) Harga periode lalu (Pt. Rp 1. Data untuk tiga saham A.RF]  = Ri – E(r) . Contoh 2  Diketahui expected return dari index pasar adalah 11%. Suku bunga SBI sebesar 8%.500 Rp 1.5 Return Realisasi : Ri= (Pt .Pt-1) / Pt-1 Expected Return : E(ri)= RF + i [E(rM).350 Rp 5.000 Rp 5.

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