Portfolio Managment

3-228-07
Albert Lee Chun

Proof of the Capital Asset

Pricing Model

Lecture 6
0
 Course Outline
 Sessions 1 and 2 : The Institutional Environment
 Sessions 3, 4 and 5: Construction of Portfolios
 Sessions 6 and 7: Capital Asset Pricing Model
 Session 8: Market Efficiency
 Session 9: Active Portfolio Management
 Session 10: Management of Bond Portfolios
 Session 11: Performance Measurement of Managed
Portfolios

1
 Plan for Today
 Fun Proof of the CAPM
 Zero-Beta CAPM (not on the syllabus)
 A few examples
 Revision for the mid-term

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 A Fun Proof of the CAPM

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 CAPM Says that
for any security i that we pick,
the expected return of that
E(R port ) security is given by Capital
Market
Line

security i

 port
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 Why does CAPM work?
Green line traces out the
E(R port ) set of possible portfolios P
Capital
using security i and M by Market
varying w, Line

M where w is the
P weight on
security i in
portfolio P
Rf security i

 port
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 Why does CAPM work?
Note that w=1 corresponds
E(R port ) to security i and w=0
Capital
gives us the market Market
portfolio M, Line

w=0 M where w is the

P weight on
security i in
portfolio P
Rf security i

w=1

 port
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 Why does CAPM work?
For any weight w, we can
easily compute the expected
E(R port ) return and the variance of Capital
portfolio P, Market
Line

w=0 M where w is the

P weight on
security i in
portfolio P
Rf security i

w=1

 port
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 Why does CAPM work?
Note that the CML (orange
line) is tangent to both the
E(R port ) risky efficient frontier (blue
Capital
line) and the green line at M.
Market
Line

w=0 M
P
Intuition: The orange
line, the blue line and
the green line all touch
Rf security i at only 1 point M.
w=1 Why?

 port
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 Why does CAPM work?

Slope of the green line at

E(R port ) M, is equal to the slope of
Capital
the blue line at M which is Market
equal to the slope of the Line
CML(orange line)!

w=0 M
Intuition: The orange
line, the blue line and
the green line all touch
Rf security i at only 1 point M.
Why?

 port
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 Why does CAPM work?
Slope of the green line at M, is
equal to the slope of the blue line
E(R port ) at M which is equal to the slope of
Capital
the CML(orange line)! Market
Line

w=0 M

The slope of the CML

Rf security i

 port
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 Why does CAPM work?
(slope = slope = slope)
E(R port ) Capital
Market
Line

w=0 M
Therefore, the slope of
all 3 lines at M is

Rf security i

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 Why does CAPM work?
Mathematically the slope of the green
line at M is:
E(R port ) Capital
Market
Line

w=0 M
The slope of all 3 lines
at M is

Rf security i

 port
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 Why does CAPM work?
Note that we can also express the slope of the green line as as:

E(R port )

w=0 This slope has to

M equal the slope of
the CML at M!

Rf security i =

 port
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 We want to Proof of CAPM
find the slope
of the green
line
by
differentiating
these at w = 0
and using this
relation
to set the slope
at (w = 0)
equal to the
=
slope of the
CML
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 Proof of CAPM

E(R port )
=

w=0 M

Rf security i
To prove CAPM we use the fact that the green slope has to
equal the slope of the CML at M.
 port
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 Let’s Take a Few Derivatives

Derivative of expected
return w.r.t w.

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 Let’s Take a Few Derivatives

Derivative of standard deviation w.r.t. w

Evaluate the derivative at w = 0, which is at the market portfolio!

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 Equate the Slopes

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 Equating the Slopes

Capital
Market
Line

w=0 M

Rf security i

 port
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 Now Solve for E(Ri)

Voila! We just proved the CAPM!!

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 We just showed that
for any security i that we pick,
the expected return of that
E(R port ) security is given by

Rf security i So we just won the

Nobel Prize!
 port
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 Zero-Beta Capital Asset Pricing Model
(Not on the Syllabus: However, understanding this might be
useful for solving other problems on the exam.)

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 Suppose There is No Risk Free Asset
Can we say something about the expected
return of a particular asset in this
E(R port ) economy?
Efficient
frontier

 port
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 Zero Beta CAPM
Fisher Black (1972)

There exists an efficient portfolio that is uncorrelated

with the market portfolio, hence it has zero beta.

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 Zero-Beta CAPM World

E(R i )
Efficient
frontier

E(R ZB ) Zero-Beta
Portfolio

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 Zero-Beta SML

E(R i )
SML

E(R M )

E(R ZB )

0 1.0 Beta
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 Example CAPM
Suppose there are 2 efficient risky securities:
Security E(r) Beta
Egg 0.07 0.50
Bert 0.10 0.80
You do not know E(Rm) or Rf.

Suppose that Karina is thinking about buying the following:

Security E(r) Beta
Karina 0.16 1.30

Should she buy the security?

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 Under Valued or Overvalued
Undervalued
E(ri ) Buy!

SML
Market
E(rm ) Bert
Egg
Overvalued
rf Don`t Buy!

0 1.0 Beta
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 Example CAPM
We know that for the two efficient securities:
E(REgg) = rf + BEgg(E(Rm)- Rf)
E(RBert) = rf + BBert(E(Rm)- Rf)

And if Karina is an efficient security we would have:

E(RKarina) = rf + BKarina(E(Rm) - Rf)

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 Example CAPM
First find the expected return on the market and the risk-free
retrun by solving 2 equations in 2 unknowns:

E(REgg) = (1- BEgg) Rf + BEgg E(Rm)

E(RBert) = (1- BBert) Rf + BBert E(Rm)
Some algebra:
(E(REgg) - (1- BEgg) Rf )/ BEgg = (E(RBert) - (1- BBert) Rf )/ BBert

Rf = [BBert E(REgg) - BEgg E(RBert)]/ [BEgg(1-BBert ) + BBert (1- BEgg) ]

E(Rm)= (E(REgg) - (1- BEgg) Rf )/ BEgg

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 Example CAPM

Security E(r) Beta

Egg .07 .5
Bert .1 .8
Karina .16 1.3

Rf = [BBert E(REgg) - BEgg E(RBert)]/ [-BEgg(1-BBert ) + BBert (1- BEgg)

]
= .02
E(Rm)= (E(REgg) - (1- BEgg) Rf )/ BEgg
= .12

E(RKarina) = rf + BKarina(E(Rm) - Rf)

=.02 + 1.3*(.12 - .02) = .15 < .16
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 Stock is Under Valued
Undervalued Karina
E(ri ) Buy!
16%
SML
Market 15%
E(rm ) Bert
Egg

rf

0 1.0 Béta
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 Another Example
State of the Probability Return Rerurn Risk-Free Rate
Economy Eggbert Dingo

Bad 0.20 0.04 0.07 0.03

Good 0.45 0.10 0.10 0.03
Great 0.35 0.22 0.19 0.03
Expected ? ?
Return
Variance ? ?

Coefficient of 0.712 0.842

Correlation
with the
market
Covariance with 0.0015 ?
the Market

Albert Lee Chun Portfolio Management

 Example
The expected return on the market portfolio is 9%.
A) Determine the covariance between the return on
Dingo and the return on the market portfolio.

B) Determine the rate of return on Dingo using CAPM.

Would you recommend that investors buy shares of
Dingo? (Justify your answer)

Albert Lee Chun Portfolio Management

 Solution :
E(re) = 13,00%
E(rd) = 12,55%
Var(re) = 0,004860
Var(rd) = 0,002365
STD(re) = 0,069714
STD(rd) = 0,048629
STD Market= 0,030220
Var Market = 0,000913
Covariance of Dingo with the market = 0,001237
Beta of Dingo = 1,35
Expected Reeturn of the Market = 9%
Expect Return of Dingo according to CAPM :
E(rd) = Rf + BetaDingo (E(Rm) - Rf) = 11,13%
12,55% > 11,13% - Buy! Lies above the SML.

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 Midterm
 Focus on solving examples that I gave you to do at
home and what we did in class.
 Do the math as well as know the intuition.
 The lecture notes are more important than the book,
although the book is important too.
 Focus on Lectures 3 – 6

Albert Lee Chun Portfolio Management