Capital Market Line
Line from RF to L is
L capital market line (CML)
x = risk premium
M
E(RM) = E(RM) - RF
y = risk = σ M
x
Slope = x/y
RF = [E(RM) - RF]/σ
y M
y-intercept = RF
σ M
Risk
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(R M ) − RF
E(R p ) = RF + σp
σM
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?
Security Market Line
Equation for expected return for an individual
stock similar to CML Equation
E(R M ) − RF σ i,M
E(R i ) = RF +
σM σM
= RF + β i [ E(R M ) − RF]
Security Market Line
Beta = 1.0 implies as
SM risky as market
L Securities A and B are
E(R)
more risky than the
A market
E(RM) B Beta > 1.0
C Security C is less risky
RF
than the market
Beta < 1.0
0 0.5 1.0 1.5 2.0
BetaM
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
SML and Asset Values
Er
Underpriced SML: Er = rf + β (Erm – rf)
Overpriced
rf
β
Underpriced ⇒ expected return > required return according to CAPM
⇒ lie “above” SML
Overpriced ⇒ expected return < required return according to CAPM
⇒ lie “below” SML
Correctly priced ⇒ expected return = required return according to CAPM
⇒ lie along SML
CAPM’s Expected Return-Beta
Relationship
Required rate of return on an asset (ki) is
composed of
risk-free rate (RF)
risk premium (β i [ E(RM) - RF ])
Market risk premium adjusted for specific security
ki = RF +β i [ E(RM) - RF ]
The greater the systematic risk, the greater the required
return
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
Estimating Beta
Market model
Relates the return on each stock to the return on the
market, assuming a linear relationship
Rit =α i +β i RMt + eit
Test of CAPM
Empirical SML is “flatter” than predicted SML
Fama and French (1992)
Market
Size
Book-to-market ratio
Roll’s Critique
True market portfolio is unobservable
Tests of CAPM are merely tests of the mean-variance
efficiency of the chosen market proxy
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
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
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(Rit) =a0+bi1 (risk premium for factor 1) +bi2 (risk
premium for factor 2) +… +bin (risk premium
for factor n)
APT Model
Reduces to CAPM if there is only one factor and
that factor is market risk
Roll and Ross (1980) Factors:
Changes in expected inflation
Unanticipated changes in inflation
Unanticipated changes in industrial production
Unanticipated changes in the default risk premium
Unanticipated changes in the term structure of interest
rates
Problems with APT
Factors are not well specified ex ante
To implement the APT model, the factors that account
for the differences among security returns are required
CAPM identifies market portfolio as single factor
Neither CAPM or APT has been proven superior
Both rely on unobservable expectations
Two-Security Case
For a two-security portfolio containing Stock A and
Stock B, the variance is:
σ = x σ + x σ + 2 xA xB ρ ABσ Aσ B
2
p
2
A
2
A
2
B
2
B
17
Two Security Case (cont’d)
Example
Assume the following statistics for Stock A and Stock B:
Stock A Stock B
Expected return .015 .020
Variance .050 .060
Standard deviation .224 .245
Weight 40% 60%
Correlation coefficient .50
18
Two Security Case (cont’d)
19
Example (cont’d)
What is the expected return and variance of this two-security
portfolio?
Two Security Case (cont’d)
20
Example (cont’d)
Solution: The expected return of this two-security portfolio is:
n
E ( R%
p ) = ∑ x
i
i =1
E ( %)
Ri
= x A E ( R%)
A
+ x
B E ( %)
RB
= [ 0.4(0.015)] + [ 0.6(0.020) ]
= 0.018 = 1.80%
Two Security Case (cont’d)
21
Example (cont’d)
Solution (cont’d): The variance of this two-security portfolio is:
σ 2p = x A2σ A2 + xB2 σ B2 + 2 xA xB ρ ABσ Aσ B
= (.4) (.05) + (.6) (.06) + 2(.4)(.6)(.5)(.224)(.245)
2 2
= .0080 + .0216 + .0132
= .0428
Minimum Variance Portfolio
22
The minimum variance portfolio is the particular
combination of securities that will result in the least
possible variance
Solving for the minimum variance portfolio requires
basic calculus
Minimum Variance
Portfolio (cont’d)
23
For a two-security minimum variance portfolio, the
proportions invested in stocks A and B are:
σ − σ Aσ B ρ AB
2
xA = 2 B
σ A + σ B − 2σ Aσ B ρ AB
2
xB = 1 − x A
Minimum Variance
Portfolio (cont’d)
24
Example (cont’d)
Assume the same statistics for Stocks A and B as in the previous example.
What are the weights of the minimum variance portfolio in this case?
Minimum Variance
Portfolio (cont’d)
25
Example (cont’d)
Solution: The weights of the minimum variance portfolios in this case
are:
σ B2 − σ Aσ B ρ AB .06 − (.224)(.245)(.5)
xA = 2 = = 59.07%
σ A + σ B − 2σ Aσ B ρ AB .05 + .06 − 2(.224)(.245)(.5)
2
xB = 1 − x A = 1 − .5907 = 40.93%
Minimum Variance
Portfolio (cont’d)
26
Example (cont’d)
1.2
0.8
0.6
At hgi e W
0.4
0.2
0
0 0.01 0.02 0.03 0.04 0.05 0.06
Portfolio Variance
Correlation and
Risk Reduction
27
Portfolio risk decreases as the correlation coefficient
in the returns of two securities decreases
Risk reduction is greatest when the securities are
perfectly negatively correlated
If the securities are perfectly positively correlated,
there is no risk reduction
The n-Security Case
28
For an n-security portfolio, the variance is:
n n
σ = ∑∑ xi x j ρijσ iσ j
2
p
i =1 j =1
where xi = proportion of total investment in Security i
ρij = correlation coefficient between
Security i and Security j
The n-Security Case (cont’d)
29
A covariance matrix is a tabular presentation of
the pairwise combinations of all portfolio
components
The required number of covariances to compute a portfolio
variance is (n2 – n)/2
Any portfolio construction technique using the full covariance
matrix is called a Markowitz model
Computational Advantages
30
The single-index model compares all securities to
a single benchmark
An alternative to comparing a security to each of the others
By observing how two independent securities behave relative
to a third value, we learn something about how the securities
are likely to behave relative to each other
Computational
Advantages (cont’d)
31
A single index drastically reduces the number of
computations needed to determine portfolio variance
A security’s beta is an example:
COV ( R% %
i , Rm )
βi =
σ m2
where R% = return on the market index
m
σ m2 = variance of the market returns
R% i = return on Security i
Portfolio Statistics With the Single-Index
Model
32
Beta of a portfolio:
n
β = ∑ xi βi
Variance of a portfolio:
p
i =1
σ 2p = β p2σ m2 + σ ep2
≈ β p2σ m2
Portfolio Statistics With the Single-Index
Model (cont’d)
33
Variance of a portfolio component:
σ = β σ +σ
i
2
i
2 2
m
2
ei
Covariance of two portfolio components:
σ AB = β A β Bσ 2
m
