Chapter 18

CAPITAL ASSET PRICING THEORY

• What is the capital market line (CML)?
• How is the Capital Asset Pricing Model
(CAPM) developed?
• What is the difference between the
standard deviation risk and beta risk
measures?
• How can an investor apply the CAPM to
security analysis?
• How do you estimate beta?
• What are the good news and the bad news
about beta? Contemporary Investments: Chapter 18
Assumptions of the Capital
Asset Pricing Model
• Investors have homogeneous
expectations
• Frictionless capital markets
• Investors are rational and seek to
maximize their expected utility functions
• Investment is for one-period only
• All investors can borrow or lend at the
riskfree rate

Contemporary Investments: Chapter 18

Efficient frontier and the
optimal risky portfolio
• Developing the capital market line
(CML)
– Introducing the riskfree asset.
– The capital market line (CML) or the
borrowing-lending line.
– The Portfolio Separation Theorem
– The market portfolio, M

Contemporary Investments: Chapter 18

Figure 18.1 – Efficient Frontier

Contemporary Investments: Chapter 18

Figure 18.2 – Efficient Frontier and Utility
Curves for Investors A and B

Contemporary Investments: Chapter 18

Figure 18.3 – Combinations of the
Risk-Free Asset RF and
Risky Portfolios P1 and P2

Contemporary Investments: Chapter 18

Figure 18.4 – Combinations of the
Risk-Free Asset RF and
the Risky Portfolio M

Contemporary Investments: Chapter 18

Figure 18.5 – CML and Individual Utility Curves

Contemporary Investments: Chapter 18

Figure 18.6 – CML: The Borrowing-Lending Line

Contemporary Investments: Chapter 18

Capital Asset Pricing Model
• Developing a relative risk measure
• Understanding beta
– Systematic risk or market risk
– Diversifiable risk or firm-specific risk

Contemporary Investments: Chapter 18

Figure 18.7 – CML and Individual Securities

Contemporary Investments: Chapter 18

CAPM derivation
• Security risk and return
– Reward for investing in a security
– Security risk
– Security’s reward-to-risk ratio
– Risk/return relationship
– The security market line (SML)
• Differences between the CML and SML

Contemporary Investments: Chapter 18

Figure 18.8 – Security Market Line (SML)

Contemporary Investments: Chapter 18

CAPM and security analysis
• Estimating the required return.
• Estimating the predicted return.
• Security analysis decision rule.
• Comparison with fundamental
analysis.

Contemporary Investments: Chapter 18

Estimating Beta
• Security characteristic line
• Information service beta estimates
• Calculating beta: Separating
systematic risk from diversifiable
risk.
• Differences between the SML and the
security characteristic line
Contemporary Investments: Chapter 18
Good news and bad news
about Beta
• How reliable are beta estimates?
• Does beta really measure risk?
• The verdict on beta.

• Implications for investors

Contemporary Investments: Chapter 18

Figure 18.9 – Security Market Line Analysis

Contemporary Investments: Chapter 18

Figure 18.10 – Regression Analysis to
Estimate Beta

Contemporary Investments: Chapter 18