Week 6 - Capital Asset Pricing Model

BAO3403 Investment and Portfolio
Management
Week 6
Chapter 7
Capital Asset Pricing Model
1
Learning objectives
LO7.1 Describe the capital asset pricing model
(CAPM).
LO7.2 Construct and explain the security market line.
LO7.3 Construct the index model.
LO7.4 Calculate the beta of a share.
LO7.5 Discuss the results of the CAPM when applied to
actual share data.
LO7.6 Describe a multifactor model; explain the Fama-
French three-factor model.
LO7.7 Discuss the arbitrage pricing theory (APT).
LO7.8 Compare the APT and the CAPM.
Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Bodie, Drew, Basu, Kane and Marcus Principles of Investments,
1e 7-2
7.1 THE CAPITAL ASSET PRICING
MODEL

Bodie, Drew, Basu, Kane and Marcus Principles of Investments, 7-3
1e
Capital asset pricing model (CAPM)
• Equilibrium model that underlies all

modern financial theory
• Derived using principles of
diversification, but with other simplifying
assumptions
• Markowitz, Sharpe, Lintner and Mossin
are researchers credited with its
development

7-4
1e
Simplifying assumptions
• Individual investors are price takers
• Single-period investment horizon
• Investments are limited to traded

financial assets
• No taxes and no transaction

costs
1e
Simplifying assumptions (cont.)
• Information is costless and available to all

investors
• Investors are rational mean-variance

optimisers
• Homogeneous expectations

1e
Resulting equilibrium conditions
• All investors will hold the same portfolio

for risky assets; the 'market portfolio'
• Market portfolio contains all securities and
the proportion of each security is its
market value as a percentage of total
market value
• Market price of risk or return per unit of
risk depends on the average risk aversion
of all market participants
1e 7-7
Capital market line
M = The value weighted 'market'

E(r) portfolio of all risky assets.
CML
M
E(rM ) Efficient
frontier
rf

m
1e
Known tangency portfolio of CML
• Equilibrium conditions: all investors will

hold the same portfolio for risky
assets; the 'market portfolio'
Capital Market Line Pricing of individual securities
E(r) M = The value weighted “Market”
Portfolio of all risky assets.
is related to the risk
that individual securities
CML have when they are
M
E(rM) included in the market
rf portfolio.

m

7-9
1e
Slope and market risk premium
Capital Market Line
M = The value weighted “Market”
E(r) Portfolio of all risky assets.
M Market portfolio E(rM)

M
CML
rf
Risk free rate
f 
= Excess return on
m
the market portfolio

r =
{
E(r=M) Optimal market price of risk
= Slope of the CML
- rf
=
1e
Expected return and risk on individual
securities
• The risk premium on individual securities is a
function of the individual security’s contribution to
the risk of the market portfolio
• What type of individual security risk will matter,
systematic or unsystematic risk?
• On the basis that a fully diversified portfolio will
have eliminated non-systematic risk, the only risk
we need to consider is systematic. In other
works there is reward for taking on systematic risk
but no reward for taking on non-systematic risk
1e 7-11
Expected return and risk on individual
securities (cont.)
• An individual security’s contribution to the risk of the
market portfolio is a function of the covariance of the
share’s returns with the market portfolio’s returns and is
measured by BETA
• With respect to an individual security, systematic risk can
be measured by:
βi = [COV(ri,rM)] / 2M
• We saw in the last lecture that beta can also be

calculated by regressing the excess returns on an asset
over the excess returns on a market portfolio

1e 7-12
Capital Asset Pricing Model (CAPM)
E(Ri )  RF  βi [E(RM )  RF ],
• Where
– E(Ri) = Required return on equity for security i
– RF = Current expected risk-free return
– i = Beta of security i
– E(RM) = Expected return on the market portfolio
– E(RM) – RF = Market risk premium
• Assumptions
– Investors are risk averse
– Investment is based on mean–variance
optimization
– Relevant risk is systematic risk
7-13
1e
Individual shares: security market line
Slope SML = (E(rM) – rf )/ βM

E(r) = price of risk for market
Equation of the SML (CAPM)
E(ri) = rf + βi[E(rM) - rf]
SML
E(rM)
rf
β
β = 1.0
M

1e
Sample calculations for SML
Equation of the SML
Let’s do an example…
E(ri) = rf + i[E(rM) - rf]
E(rm) - rf = .08 rf = .03

Return per unit of systematic risk = 8% = Market Risk Premium
βx = 1.25
E(rx) = 0.03 + 1.25(0.08) = 0.13 or
13%
βy = .6
E(ry) = 0.03 + 0.6(0.08) = 0.078 or

7.8%
If β = 1?
If β =
1e 7-15
Graph of sample calculations
E(r)
SML
Rx=13%
RM=11% (E(ri) – rf) / βi
Ry=7.8% = Slope = 8.0
3%
ß
0.6 1.0 1.25
βy βM βx

1e 7-16
Graph of sample calculations (cont.)
Disequilibrium Example
Suppose a security with a  of 1.25 is
E(r) offering an expected return of 15% as
SM per our research.
15% L According to the SML, the E(r) should
13%
Rm=11% be 13%
E(r) = 0.03 + 1.25(.08) = 13%
rf=3
% ß
1.0
Is the security under
1.25 or overpriced?
Underpriced: It is offering too high of a rate of return for its level of risk
The difference between the expected required for the risk level as measured
by the CAPM and the expected return via our research is called the share’s
alpha denoted by   = +2% Positive  is good, negative  is
What is the  in this case? bad
Share price should rise +  gives the buyer a + abnormal return

1e
More on alpha and beta
E(rM) =
14%
βS = 1.5
rRequired
f 5%
= return = rf + β S [E(rM) – rf]
= 5 + 1.5 [14 – 5] = 18.5%
If you believe the share will actually provide a return of
17%, what is the implied alpha?
 = 17% - 18.5% = -1.5%
A share with a negative alpha plots below the
SML (as is it is overpriced) & gives the buyer a
negative abnormal return. Share price should fall
Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd 7-18

1e
Portfolio betas
βP = W β
i i
If you put half your money in a share with a beta of 1.5

and 30%_ of your money in a share with a beta of
0.9 and the rest in T-bills, what is the portfolio beta?
βP =All 0.50(1.5)
portfolio beta expected return combinations
• + 0.30(0.9) + 0.20(0) = 1.02
should also fall on the SML.
• All (E(ri) – rf) / βi (or slope) should be the same
for all stocks.

1e 7-19
Measuring beta
• Concept
We need to estimate the relationship between the
security and the 'market' portfolio.
• Method
Can calculate the security characteristic line or SCL
using historical time series excess returns of the
security and a proxy for the market portfolio.
– The proxy can be an accumulation stock market index
such as the ASX 200 or 300 in Australia or the
S&P500 in the USA
– Note that an accumulation index includes dividends

1e 7-20
7.2 THE CAPM AND INDEX MODELS

1e 7-21
Security characteristic line (SCL)
Excess Returns (i) SCL
Dispersion of the points
around the line comes
from unsystematic risk
. .. Slope = ß
. . . i
. .. . . . .
.. . . .
. . . .
. .
.  i
. Excess returns
. .. . . . . .
on market index
. . . . . . . . .
. . . Ri = . i + ßiRM + ei
.
1e 7-22
Adjusted betas
Calculated betas are adjusted to account for the
empirical finding that betas different from 1 tend to
move toward 1 over time.
A firm with a beta >1 will tend to have a lower beta

(closer to 1) in the future. A firm with a beta <1 will tend
to have a higher beta (closer to 1) in the future.
Adjusted β = 2/3 (calculated β) + 1/3 (1)

= 2/3 (1.276) + 1/3 (1)
= 1.184

1e 7-23
7.3 THE CAPM AND THE REAL
WORLD

1e
Evaluating the CAPM
• The CAPM is 'false' based on the validity of its
assumptions.
• The CAPM could still be a useful predictor of

expected returns. That is an empirical
question.
• Huge measurability problems because the market

portfolio is unobservable.
Conclusion: As a theory the CAPM is untestable.

1e 7-25
Evaluating the CAPM (cont.)
• However, the of the CAPM is

practicality testable.
Betas are not as useful at predicting
returns as other measurable factors may
be.
 More advanced versions of the CAPM
that do a better job at
estimating the market portfolio
_ are
more
Copyright ©useful atEducation
2013 McGraw-Hill predicting
(Australia) Pty Ltd stock
returns. 1e
7-26
Evaluating the CAPM (cont.)
– The principles we learn from the CAPM are still

entirely valid.
 Investors should diversify.
 Systematic risk is the risk that matters.
 A well diversified risky portfolio can be suitable
for a wide range of investors.
• The risky portfolio would have to be adjusted for
tax and liquidity differences.
• Differences in risk tolerances can be handled
by changing the asset allocation decisions in
the complete portfolio.
– Even if the CAPM is 'false', the markets can still
be 'efficient'.
1e
7-27
7.4 MULTIFACTOR MODELS AND
THE CAPM
1e 7-28
Fama-French (FF) 3-factor model
• Fama and French noted that shares of smaller firms
and shares of firms with a high book to market have
had higher share returns than predicted by single factor
models.
• The FFM and the CAPM share the risk-free return
and the market risk premium factor (MRP).
• The FFM adds two other factors to determine the
required return on a stock. One factor reflects the size
of the firm, and the other factor reflects the degree to
which the stock is considered a value or growth stock.

1e
Capital Asset Pricing Model (CAPM)
Market
Size
Risk
Premium
Premium
Risk-
Free Value
Return Required Premium
Return
on
Equity

1e 7-30
Fama-French (FF) 3-factor model (cont.)
FF proposed a 3-factor model of share returns as
follows:
• rM – rf = Market index excess return
• Ratio of book value of equity to market value of
_equity measured with a variable called HML
– HML:
 High minus low or difference in returns between firms
with a high versus a low book-to-market ratio.
• Firm size variable_ measured by the SMB
variable
– SMB:
 Small minus big or the difference in returns
between
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large firms.
Pty Ltd
1e 7-31
FAMA – FRENCH
MODEL
r R  βmkt RMRF  βsizeSMB  βvalueHML,
i F i i i
• where
– RMRF = E(rM) – rf. It is specifically the return on a market
value-weighted index in excess of the one- month T-Bill rate.
It is commonly called the Market Risk Premium or Equity Risk
Premium.
– SMB = The return to small stocks minus the return to large
stocks
– βsize = The sensitivity of security i to movements in small
stocks
– HML = The return to value stocks minus the return
to growth stocks
– βvalue = The sensitivity of security i to movements in value stocks

1e 7-32
The PASTOR–STAMBAUGH MODEL goes
further
• r  R  βmkt RMRF  βsizeSMB 
βvalueHML  βliq LIQ,
• i F i i i
i
• where
– LIQ = The return to illiquid stocks minus
the return to liquid stocks
– βliq = The sensitivity of security i to
movements in illiquid stocks

1e 7-33
Example: FAMA – FRENCH MODEL
Risk-free rate 3.0%

Equity risk premium 5.0%
Beta 1.20
Size premium 2.2%
Size beta 0.12
Value premium 3.8%
Value beta 0.34

1e
7-34
Example: FAMA – FRENCH MODEL
ri  RF  βimkt RMRF  βi sizeSMB  βi value

HML 3% 1.20(5%)  0.12(2.2%) 
0.34(3.8%)
 10.56%

1e 7-35
7.5 FACTOR MODELS AND THE
ARBITRAGE PRICING THEORY
1e 7-36
Arbitrage pricing theory (APT)
● Arbitrage: Arises if an investor can construct

a zero investment portfolio with a
sure profit
● Zero investment: Since no net investment outlay is
required, an investor can create
arbitrarily large positions to
secure
large levels of profit
● Efficient markets: With efficient markets, profitable
arbitrage opportunities will quickly
disappear

1e 7-37
Simple arbitrage example
If all of these stocks cost $8_

today are there any arbitrage
opportunities?
Portfolio Cost Final Outcome

Short C 8 9
Buy (A+B) / 2 8 10
• The A&B combo dominates portfolio C, but costs the same.

• Arbitrage opportunity: buy A&B combo and short C, $0
net investment, sure gain of $1
• The opportunity should not persist in competitive capital
markets.
1e 7-38
Arbitrage pricing example
Suppose Rf = 6% and a well diversified portfolio P has a beta of 1.3

and an alpha of 2% when regressed against a systematic factor S. Another
well diversified portfolio Q has a beta of 0.9 and an alpha of
WP .= -2.25 and WQ = 3.25;

1% WP = - β Q / (β P - β Q)
If we construct a portfolio of P and Q with the following
WQ = β P weights:
/ (β P - β Q)
Then βp = (-2.25 x 1.3) + (3.25 x 0.9) = 0
Note: Σ W = 1
αp = (-2.25 x 2%) + (3.25 x 1%) = - 1.25%
αp = -1.25%
What shouldmeans
αp = 0an investor will earn rf – 1.25% or 4.75% on
portfolio PQ.
In theory one could short this portfolio and pay 4.75%, and invest
in the riskless asset and earn 6%, netting the 1.25% difference.
Arbitrage should eliminate the negative portfolio alpha quickly.

1e 7-39
Arbitrage pricing model
The result: for a well diversified

portfolio Rp = βpRS (Excess returns)
(rp,i – rf) = βp(rS,i – rf)
RS is the excess return on
a portfolio with a beta of
and for an individual security 1 relative to systematic
(rp,i – rf) = βp(rS,i – rf) + ei factor 'S'
Advantage of the APT over the CAPM:

• No particular role for the 'market portfolio', which can’t be
measured anyway
• Easily extended to multiple systematic factors, for
example
- (–rp,i – rf) = βp,1(r1,i – rf) + βp,2(r2,i – rf) + βp,3(r3,i – rf) + ei

1e 7-40
APT and CAPM
APT applies to well diversified portfolios but not necessarily to
all individual stocks
APT employs fewer restrictive assumptions
APT does NOT specify the systematic

factors Chen, Roll and Ross (1986)
suggest:
 Yield curve
 Industrial production
 Default spreads
 Inflation
In order to actually use this you would:
• need to find 4 well diversified portfolios: Portfolio 1 would have to have a
beta of 1 wrt Δ industrial production and betas of zero on the other 3 factors.
• Portfolio 2 would have to have a beta of 1 wrt Δ yield curve and betas of
zeros wrt the other 3 factors…
(rp,i – rf) = βp,1(r1,i – rf) + βp,2(r2,i – rf) + βp,3(r3,i – rf) + βp,4(r4,i – rf) + ei

1e
Summary
• The CAPM assumes investors are rational, single period planners,
mean-variance optimisers with homogeneous expectations. The
CAPM also assumes an ideal securities market in a sense that there
are no taxes or transaction costs, investors are price takers, all risky
assets are publicly traded, and money can be borrowed and lent at
a fixed, risk-free rate.
• The CAPM implies all investors will hold the same risky portfolio and
at equilibrium the capitalisation weighted market portfolio is mean
variance efficient.
• The CAPM implies that the risk premium on any individual asset
or portfolio is the product of the risk premium of the market
portfolio and the asset’s beta.
• Multifactor generalisations of the basic CAPM may be specified
to accommodate multiple sources of systematic risk.

1e 7-42
Summary (cont.)
• A security beta can be estimated from a regression of the
security’s excess return on the index’s excess return. This
regression line is called the security characteristic line (SCL).
The intercept of the SCL, called alpha, represents the
average excess return on the security when the index excess
return is zero. The CAPM implies that alphas should be zero.
• In a single-factor security market, all well-diversified portfolios
must satisfy the expected return–beta relationship of the SML
in order to satisfy the no-arbitrage condition.
• The APT implies the same expected return–beta relationship
as the CAPM, yet does not require that all investors be mean-
variance optimisers. A multifactor APT generalises the single-
factor model to accommodate several sources of systematic
risk.

1e 7-43

Week 6 - Capital Asset Pricing Model

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BAO3403 Investment and Portfolio

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

• Equilibrium model that underlies all

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

• Single-period investment horizon

• Investments are limited to traded

• No taxes and no transaction

• Information is costless and available to all

• Investors are rational mean-variance

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

• All investors will hold the same portfolio

M = The value weighted 'market'

• Equilibrium conditions: all investors will

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

M Market portfolio E(rM)

the market portfolio

• We saw in the last lecture that beta can also be

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Slope SML = (E(rM) – rf )/ βM

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

E(rm) - rf = .08 rf = .03

E(ry) = 0.03 + 0.6(0.08) = 0.078 or

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Share price should rise +  gives the buyer a + abnormal return

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd 7-18

If you put half your money in a share with a beta of 1.5

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

A firm with a beta >1 will tend to have a lower beta

Adjusted β = 2/3 (calculated β) + 1/3 (1)

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

• The CAPM could still be a useful predictor of

• Huge measurability problems because the market

Conclusion: As a theory the CAPM is untestable.

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

• However, the of the CAPM is

– The principles we learn from the CAPM are still

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Risk-free rate 3.0%

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

ri  RF  βimkt RMRF  βi sizeSMB  βi value

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

● Arbitrage: Arises if an investor can construct

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

If all of these stocks cost $8_

Portfolio Cost Final Outcome

• The A&B combo dominates portfolio C, but costs the same.

Suppose Rf = 6% and a well diversified portfolio P has a beta of 1.3

well diversified portfolio Q has a beta of 0.9 and an alpha of

WP .= -2.25 and WQ = 3.25;

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

The result: for a well diversified

Advantage of the APT over the CAPM:

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

APT employs fewer restrictive assumptions

APT does NOT specify the systematic

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd