Chapter Nine

The Capital Asset

Pricing Model

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Capital Asset Pricing Model (CAPM)
• CAPM is a set of predictions concerning
equilibrium expected returns on risky assets
• Based on two sets of assumptions
• Individual behavior
• Market structure
• Markowitz established modern portfolio
management in 1952
• Sharpe, Lintner and Mossin published CAPM
in 1964
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Assumptions

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 The Market Portfolio
• All investors will hold the same portfolio for
risky assets — market portfolio

• Market portfolio contains all securities

• Proportion of each stock in this portfolio equals
the market value of the stock (price per share
times number of shares outstanding) divided by
the sum of the market value of all stocks

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Capital Allocation Line

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Capital Market Line

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 The Risk Premium of the Market
Portfolio
• The market risk premium is proportional to its
risk and the degree of risk aversion:
 E ( RM )  A 2
M

Where
 A  representative investor’s risk aversion
 M  variance of the market portfolio
2

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 Expected Returns on Individual
Securities
• CAPM is build on the insight that the
appropriate risk premium on an asset will be
determined by its contribution to the risk of
investors’ overall portfolios
• All investors use the same input list (i.e., they all
end up using the market as their optimal risky
portfolio)

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 Individual Securities:
Example
• Covariance of GE return with the market
portfolio:
n
 n 

i 1
wi Cov( Ri , RGE ) Cov   wi Ri , RGE 
 i 1 
• The reward-to-risk ratio for GE would be:
GE's contribution to risk premium E ( RGE )

GE's contribution to variance Cov( RGE , RM )

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 GE Example
(1 of 2)

• Reward-to-risk ratio for investment in market

portfolio (i.e., market price of risk):
Market risk premium E ( RM )
 2
Market variance  ( RM )
• Equilibrium dictates all investments should
offer the same reward-to-risk ratio
E ( RGE ) E ( RM )
 2
Cov( RGe , RM )  ( RM )

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 GE Example
(2 of 2)

• Fair risk premium for GE stock:

Cov( RGe , RM )
E ( RGE )  E ( RM )
 ( RM )
2

• Restating, we obtain:


E  rGE   rf   GE E  rM   rf 

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 Expected Return-Beta Relationship
• Expected return-beta relationship tells us the
total expected rate of return is the sum of the
risk-free rate plus a risk premium
• Risk premium is the product of a “benchmark risk
premium” and the relative risk of the particular
asset as measured by its beta

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The Security Market Line

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The SML and a Positive-Alpha Stock

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 The CAPM and the Single-Index
Market
• Index model states the realized excess return on any
stock is the sum of the following:
• Realized excess return due to marketwide factors
• A nonmarket premium
• Firm-specific outcomes

R i   i   i R M  ei
• The index model beta coefficient is the same as the
beta of the CAPM expected return-beta relationship

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 Assumptions and Extensions of the
CAPM
• Fundamental distinction between systematic
and diversifiable risk remains in each variant
of the basic model
• CAPM is build on “uncomfortably restrictive”
assumptions

• See assumption from Table 9.1

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 Extensions of the CAPM
(1 of 3)

1. Identical Input Lists

• In the absence of private information, investors
should assume alpha values are zero
2. Zero-Beta Model
• Helps to explain positive alphas on low beta stocks
and negative alphas on high beta stocks
3. Labor Income and Other Nontraded Assets
• Many assets are not tradeable (e.g., private
businesses, human capital, earning power of
individuals, etc.)
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 Extensions of the CAPM
(2 of 3)

4. Multiperiod Model and Hedge Portfolios

• Investors should be more concerned with the
stream of consumption that wealth can buy for
them

5. Consumption-Based CAPM (CCAPM)

• Rubinstein, Lucas, and Breeden
• Investors allocate wealth between consumption
today and investment for the future

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 Extensions of the CAPM
(3 of 3)

6. Liquidity
• Financial costs inhibit trades
• Liquidity of an asset is the ease and speed with
which it can be sold at fair market value
• Illiquidity can be measured in part by the
discount from fair market value a seller must
accept if the asset is to be sold quickly

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 The Relationship Between
Illiquidity and Average Returns

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 Liquidity Risk
• In a financial crisis, liquidity can unexpectedly
dry up
• When liquidity in one stock decreases, it
commonly tends to decrease in other stocks at
the same time
• Investors demand compensation for liquidity
risk, demonstrated by firms with greater
liquidity risk having higher average returns
• “Liquidity betas”
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 The CAPM and Academic World
• Testing the CAPM is surprisingly difficult
• Cannot observe all tradable assets
• Impossible to pin down market portfolio
• Both alpha and beta, as well as residual variance, are
likely time varying

• Most tests of the CAPM are directed at the mean-

beta relationship as applied to assets with respect
to an observed, but perhaps inefficient, stock
index portfolio
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The CAPM and Investment Industry
• Portfolio theory and the CAPM have become
accepted tools in the practitioner community
• Many professionals are comfortable with the use
of beta to measure systematic risk
• Most investors don’t beat the index portfolio

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