Investment Analysis and

Portfolio Management
Lecture 7
Gareth Myles
The Capital Asset Pricing Model
(CAPM)
 The CAPM is a model of equilibrium in
the market for securities.
 Previous lectures have addressed the
question of how investors should choose
assets given the observed structure of
returns.
 Now the question is changed to:
 If investors follow these strategies, how will
returns be determined in equilibrium?
The Capital Asset Pricing Model
(CAPM)
 The simplest and most fundamental model of
equilibrium in the security market
 Builds on the Markowitz model of portfolio choice
 Aggregates the choices of individual investors
 Trading ensures an equilibrium where returns
adjust so that the demand and supply of
assets are equal
 Many modifications/extensions can be made
 But basic insights always extend
Assumptions
 The CAPM is built on a set of assumptions
 Individual investors
 Investors evaluate portfolios by the mean and
variance of returns over a one period horizon
 Preferences satisfy non-satiation
 Investors are risk averse
 Trading conditions
 Assets are infinitely divisible
 Borrowing and lending can be undertaken at the risk-
free rate of return
 There are no taxes or transactions costs
Assumptions
 The risk-free rate is the same for all
 Information flows perfectly

 The set of investors

 All investors have the same time horizon
 Investors have identical expectations
Assumptions
 The first six assumptions are the Markowitz
model
 The seventh and eighth assumptions add a
perfect capital market and perfect information
 The final two assumptions make all investors
identical except for their degree of risk
aversion
Direct Implications
 All investors face the rp
same efficient set of
portfolios
rf
r MVP

 MVP p
Direct Implications
 All investors choose
a location on the rp
Less risk
efficient frontier More risk
averse
averse

 The location depends

on the degree of risk M
rf
aversion r MVP
 The chosen portfolio
mixes the risk-free
asset and portfolio M
 MVP p
of risky assets
Separation Theorem
 The optimal combination of risky assets is
determined without knowledge of preferences
 All choose portfolio M
 This is the Separation Theorem
 M must be the market portfolio of risky assets
 All investors hold it to a greater or lesser extent
 No other portfolio of risky assets is held
 There is a question about the interpretation of this
portfolio
Equilibrium
 The only assets that need to be marketed are:
 The risk-free asset
 A mutual fund representing the market portfolio
 No other assets are required
 In equilibrium there can be no short sales of
the risky assets
 All investors buy the same risky assets
 No-one can be short since all would be short
 If all are short the market is not in equilibrium
Equilibrium
 Equilibrium occurs when the demand for assets
matches the supply
 This also applies to the risk-free
 Borrowing must equal lending
 This is achieved by the adjustment of asset
prices
 As prices change so do the returns on the assets
 This process generates an equilibrium structure
of returns
The Capital Market Line
rp
 All efficient portfolios
must lie on this line

rM  r f
 Slope = rM
M
 Equation of the line rf

 rM  rf 
rp  rf    p M p
 M 
Interpretation

 rf is the reward for "time"

Patience is rewarded
 Investment delays consumption

 rM  rf is the reward for accepting "risk"

M
 The market price of risk
 Judged to be equilibrium reward

 Obtained by matching demand to supply

Security Market Line

 Now consider the implications for

individual assets
 Graph covariance against return
 The risk on the market portfolio is  M
 The covariance of the risk-free asset is zero

 The covariance of the market with the

market is  M
2
Security Market Line
 Can mix M and the risk-
rp
free asset along the line
 If there was a portfolio
above the line all
investors would buy it
 No investor would hold
rM M
one below
 The equation of the line rf
is
 rM  r f 
ri  r f   2  iM  M2  iM
  M 
Security Market Line

 Define  iM
 iM  2
M
 The equation of the line becomes

ri  rf  rM  rf  iM 
 This is the security market line (SML)
Security Market Line
 There is a linear rp
trade-off between
risk measured by  iM
and return ri
 In equilibrium all
assets and portfolios
must have risk-return rf
combinations that lie
on this line  iM
Market Model and CAPM

 Market model uses  iI

 CAPM uses  iM
  iI is derived from an assumption about
the determination of returns
 it is derived from a statistical model
 the index is chosen not specified by any
underlying analysis
 iM is derived from an equilibrium theory
Market Model and CAPM

 In addition:
 I is usually assumed to be the market index,
but in principal could be any index
 M is always the market portfolio

 There is a difference between these

 But they are often used interchangeably
 The market index is taken as an
approximation of the market portfolio
Estimation of CAPM

 Use the regression equation


ri  r f   iM   iM rM  r f   i 
 Take the expected value
E  ri  r f    iM   iM E  rM  r f 
 The security market line implies
 iM  0
 It also shows
 iI  1   iM  r f
CAPM and Pricing
 CAPM also implies the equilibrium asset prices
 The security market line is
 
ri  rf  rM  rf iM
pi 1  pi  0
 But ri 
pi  0 
where pi(0) is the value of the asset at time 0
and pi(1) is the value at time 1
CAPM and Pricing
 So the security market line gives
p i 1  p i  0
p i  0

 r f   iM rM  r f 
 This can be rearranged to find
p i 1
p i  0 

1  r f   iM rM  r f 
 The price today is related to the expected
value at the end of the holding period
CAPM and Project Appraisal

 Consider an investment project

 It requires an investment of p(0) today
 It provides a payment of p(1) in a year
 Should the project be undertaken?
 The answer is yes if the present
discounted value (PDV) of the project is
positive
CAPM and Project Appraisal

 If both p(0) and p(1) are certain then the

risk-free interest rate is used to discount
 The PDV is
p1
PDV   p 0  
1 rf
 The decision is to accept project if
p1
p 0 
1 rf
CAPM and Project Appraisal
 Now assume p(1) is uncertain
 Cannot simply discount at risk-free rate if
investors are risk averse
p 1
 For example using PDV   p 0 
1 rf
will over-value the project
 With risk aversion the project is worth less
than its expected return
U ( p (1))  EU ( p (1))
CAPM and Project Appraisal

 One method to obtain the correct value

is to adjust the rate of discount to reflect
risk
 But by how much?
 The CAPM pricing rule gives the answer
 The correct PDV of the project is
p(1)
PDV   p (0) 
1  r f   p [rM  r f ]