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CORPORATE FINANCE
Laurence Booth • W. Sean Cleary
Prepared by
Ken Hartviksen
CHAPTER 9
The Capital Asset Pricing
Model (CAPM)
Lecture Agenda
• Learning Objectives
• Important Terms
• The New Efficient Frontier
• The Capital Asset Pricing Model
• The CAPM and Market Risk
• Alternative Asset Pricing Models
• Summary and Conclusions
– Concept Review Questions
– Appendix 1 – Calculating the Ex Ante Beta
– Appendix 2 – Calculating the Ex Post Beta
10.00%
8.00%
Portfolio
6.00%
4.00%
2.00%
0.00%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0%
Standard Deviation of Returns
8 - 10 FIGURE
A is not attainable
B,E lie on the
efficient frontier and
are attainable
A B E is the minimum
Expected Return %
variance portfolio
C (lowest risk
combination)
C, D are
attainable but are
E dominated by
D superior portfolios
that line on the line
above E
Standard Deviation (%)
ERp
10 Achievable
Risky Portfolio
Combinations
ERp
30 Risky Portfolio
Combinations
The highlighted
portfolios are
ERp ‘efficient’ in that
they offer the
highest rate of
E is the return for a given
minimum level of risk.
variance Rationale investors
portfolio Achievable Set of will choose only
Risky Portfolio from this efficient
Combinations set.
Efficient
ERp frontier is the
set of
achievable
portfolio
combinations
Achievable Set of that offer the
Risky Portfolio
Combinations
highest rate
of return for a
given level of
E
risk.
9 - 1 FIGURE
Figure 9 – 1
illustrates
Efficient Frontier three
ER
achievable
portfolio
combinations
B
that are
A ‘efficient’ (no
other
achievable
MVP portfolio that
offers the
same risk,
Risk offers a higher
return.)
The possible combinations of A and RF are found graphed on the following slide.
CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 25
The New Efficient Frontier
Attainable Portfolios Using RF and A
9 - 2 FIGURE
This means
you can 9 – 2
Equation
Rearranging 9
ER achieve
illustratesany
-2 where w=σ
portfolio
what you can
p / σA and
combination
see…portfolio
substituting in
pA )- RF
E(R w A along
risk the blue
increases
[9-3] ER P[9-2]
RF P Equation 1 we
coloured
in line
A A getdirect
an
simply by to
proportion
equation for a
changing
the amount the
RF straight line
relative
invested weight
with a in the
of RFasset.
risky and A in
constant
the two asset
slope.
portfolio.
Risk
9 - 3 FIGURE
Which risky
portfolio
ER would a
rational risk-
T
averse
investor
A choose in the
presence of a
RF
RF investment?
Portfolio A?
Tangent
Risk Portfolio T?
9 - 3 FIGURE
Clearly RF with
T (the tangent
portfolio) offers
ER a series of
portfolio
combinations
T
that dominate
A those produced
by RF and A.
Further, they
RF
dominate all but
one portfolio on
the efficient
frontier!
Risk
9 - 3 FIGURE
Portfolios
between RF
and T are
Lending Portfolios ‘lending’
ER
portfolios,
because they
T
are achieved by
A investing in the
Tangent
Portfolio and
RF lending funds to
the government
(purchasing a T-
bill, the RF).
Risk
9 - 3 FIGURE
The line can be
extended to risk
levels beyond
Lending Portfolios Borrowing Portfolios ‘T’ by
ER
borrowing at RF
and investing it
T
in T. This is a
A levered
investment that
increases both
RF risk and
expected return
of the portfolio.
Risk
σρ
– Uses include:
• Determining the cost of equity capital.
• The relevant risk in the dividend discount model to estimate a stock’s intrinsic
(inherent economic worth) value. (As illustrated below)
ER
CML
σM
ER M - RF
[9-4] Slope of the CML
M
ERM - RF
[9-5] E ( RP ) RF P
σM
– Where:
• ERM = expected return on the market portfolio M
• σM = the standard deviation of returns on the market portfolio
• σP = the standard deviation of returns on the efficient portfolio being
considered
CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 41
The Capital Market Line
Using the CML – Expected versus Required Returns
9 - 6 FIGURE
B is an
C
A a portfolio that
overvalued
undervalued
offers
portfolio.
andExpected
expected
Required portfolio.
return equal
is less
Expected
tothan
the
Return on C
ER CML return
required
the required
is greater
return.
return.
Expected
than thepressure
Selling required
return on A A return.
will cause the price
to fall andfor
Demand the yield
C Portfolio
to rise until
A will
Required increase driving
expected equalsup
return on A
B the required
price, andreturn.
therefore the
Expected
Return on C
expected return will
RF
fall until expected
equals required
(market equilibrium
condition is
achieved.)
σρ
– William Sharpe identified a ratio that can be used to assess the risk-
adjusted performance of managed funds (such as mutual funds and
pension plans).
– It is called the Sharpe ratio:
ER P - RF
[9-6] Sharpe ratio
P
Return σP Sharpe β
Source: Adapted from L. Kryzanowski, S. Lazrak, and I. Ratika, " The True
Cost of Income Trusts," Canadian Investment Review 19, no. 5 (Spring
2006), Table 3, p. 15.
9 - 7 FIGURE
Market or
systematic
Unique (Non-systematic) Risk
risk is risk
that cannot
be eliminated
from the
portfolio by
investing the
Market (Systematic) Risk
portfolio into
more and
different
securities.
Number of Securities
(Figure 9 – 8 on the following slide illustrates the characteristic line used to estimate
the beta coefficient)
4
The
Theslope
plottedof
-6
COVi,M i , M i
[9-7] i 2
σM M
• The beta of a security compares the volatility of its returns to the volatility of the market
returns:
Source: Res earch Insight, Com pustat North Am erican databas e, June 2006.
[9-8] P wA A wB B ... wn n
[9-9] ki RF ( ERM RF ) i
– Where:
ki = the required return on security ‘i’
ERM – RF = market premium for risk
Βi = the beta coefficient for security ‘i’
CHAPTER 9 – The Capital Asset Pricing Model (CAPM) 9 - 60
(See Figure 9 - 9 on the following slide for the graphical representation)
The CAPM and Market Risk
The Security Market Line (SML)
9 - 9 FIGURE
ER ki RF ( ERM RF ) i
M TheSML
The SMLis
ERM uses
usedtheto
beta
predict
coefficient
requiredas
the measure
returns for
of relevant
individual
RF
risk.
securities
βM = 1 β
9 - 10 FIGURE
Similarly,
Required
A is an B returns
is an
ER ki RF ( ERM RF ) i are forecast using
undervalued
overvalued
this equation.
security
security. because
SML its
Youexpected
Investor’s
can seewillreturn
that
sell
is
thegreater
to lock than
required
in gains, the
return
required
on any
but return. is
the security
selling
Expected A
Return A pressure
a
Investors
functionwillwill
of its
Required
Return A
systematic
‘flock’
cause to
the A market
and
risk bid
(β)
B
andthe
up
price market
toprice
fall,
RF
factors (RF
causing expected
the and
markettopremium
return
expected fall
return
till itto
for risk)
equals
rise untiltheit equals
βA βB β required
the required return.
return.
– Where:
• ERi = the expected return on security i
• a0 = the expected return on a security with zero systematic risk
• bi = the sensitivity of security i to a given risk factor
• Fi = the risk premium for a given risk factor
APPENDIX 1
Calculating a Beta Coefficient Using Ex Ante
Returns
• Under the theory of the Capital Asset Pricing Model total risk is
partitioned into two parts:
– Systematic risk
– Unsystematic risk – diversifiable risk
Covariance of Returns between stock ' i' returns and the market
Beta
Variance of the Market Returns
COVi,M i , M i
[9-7] i 2
σM M
• What does the term “relevant risk” mean in the context of the CAPM?
– It is generally assumed that all investors are wealth maximizing risk
averse people
– It is also assumed that the markets where these people trade are highly
efficient
– In a highly efficient market, the prices of all the securities adjust instantly
to cause the expected return of the investment to equal the required
return
– When E(r) = R(r) then the market price of the stock equals its inherent
worth (intrinsic value)
– In this perfect world, the R(r) then will justly and appropriately
compensate the investor only for the risk that they perceive as
relevant…
– Hence investors are only rewarded for systematic risk.
NOTE: The amount of systematic risk varies by investment. High systematic risk
occurs when R-square is high, and the beta coefficient is greater than 1.0
Cov(k i k M )
Beta
Var(k M )
You need to calculate the covariance of the returns between the
stock and the market…as well as the variance of the market
returns. To do this you must follow these steps:
• Calculate the expected returns for the stock and the market
• Using the expected returns for each, measure the variance
and standard deviation of both return distributions
• Now calculate the covariance
• Use the results to calculate the beta
This means that we have considered all of the possible outcomes in this discrete
probability distribution
Possible
Future State Possible Possible
of the Returns on Returns on
Economy Probability the Stock the Market
Boom 25.0% 28.0% 20.0%
Normal 50.0% 17.0% 11.0%
Recession 25.0% -14.0% -4.0%
100.0%
From Chapter 8 you know the formula for the covariance between the
returns on the stock and the returns on the market is:
n _ _
[8-12] COVAB Prob i (k A,i ki )( k B ,i - k B )
i 1
The formula for the correlation coefficient between the returns on the stock and the returns on
the market is:
COVAB
[8-13] AB
A B
The correlation coefficient will always have a value in the range of +1 to -1.
+1 – is perfect positive correlation (there is no diversification potential when combining these two
securities together in a two-asset portfolio.)
- 1 - is perfect negative correlation (there should be a relative weighting mix of these two
securities in a two-asset portfolio that will eliminate all portfolio risk)
Using the expected return (mean return) and given data measure the deviations for
both the market and the stock and multiply them together with the probability of
occurrence…then add the products up.
Now you can substitute the values for covariance and the variance of the
returns on the market to find the beta of the stock:
CovS, M .01335
Beta 1.8
Var M .007425
Since the variance of the returns on the market is = .007425 …the beta for
the market is indeed equal to 1.0 !!!
If you now place the covariance of the market with itself value in the
beta formula you get:
Cov MM .007425
Beta 1.0
Var(R M ) .007425
% Return
E(Rs) = 5.0%
R(ks) = 4.76%
SML
E(kM)= 4.2%
Risk-free Rate = 3%
% Return
Risk-free Rate = 3%
APPENDIX 2
The Regression Approach to Measuring the
Beta
• You need to gather historical data about the stock and the market
• You can use annual data, monthly data, weekly data or daily data.
However, monthly holding period returns are most commonly used.
• Daily data is too ‘noisy’ (short-term random volatility)
• Annual data will extend too far back in to time
• You need at least thirty (30) observations of historical data.
• Hopefully, the period over which you study the historical returns of the
stock is representative of the normal condition of the firm and its
relationship to the market.
• If the firm has changed fundamentally since these data were produced
(for example, the firm may have merged with another firm or have
divested itself of a major subsidiary) there is good reason to believe
that future returns will not reflect the past…and this approach to beta
estimation SHOULD NOT be used….rather, use the ex ante approach.
In this example, we have regressed the quarterly returns on the stock against the
quarterly returns of a surrogate for the market (TSE 300 total return composite
index) and then using Excel…used the charting feature to plot the historical
points and add a regression trend line.
The ‘cloud’ of plotted points
Period HPR(Stock)
represents HPR(TSE
‘diversifiable 300)
or company C h a r a c t e r is t ic Lin e ( R e g r e s s io n )
2006.4
specific’ risk-4.0% 1.2%
in the securities returns 30.0%
2006.3 -16.0% -7.0%
that can be eliminated from a portfolio 25.0%
2006.2 32.0%
through diversification. 12.0%
Since 20.0%
2006.1 16.0%
company-specific 8.0%be
risk can
Returns on Stock
15.0%
eliminated,-22.0%
2005.4 investors don’t require
-11.0%
compensation
2005.3 15.0%for it according
16.0% to 10.0%
2005.2Markowitz Portfolio Theory.
28.0% 13.0% 5.0%
2005.1 19.0% 7.0% 0.0%
2004.4 -16.0% -4.0% -40.0% -20.0% -5.0%0.0% 20.0% 40.0%
The regression line is a line of ‘best
2004.3 8.0% 16.0%
fit’ that describes the inherent -10.0%
2004.2 -3.0% -11.0%
relationship between the returns on -15.0%
2004.1 34.0% 25.0%
the stock and the returns on the Returns on TSE 300
market. The slope is the beta
coefficient.
• The degree to which the characteristic line explains the variability in the dependent
variable (returns on the stock) is measured by the coefficient of determination.
(also known as the R2 (r-squared or coefficient of determination)).
• If the coefficient of determination equals 1.00, this would mean that all of the
points of observation would lie on the line. This would mean that the characteristic
line would explain 100% of the variability of the dependent variable.
• The alpha is the vertical intercept of the regression (characteristic line). Many
stock analysts search out stocks with high alphas.
Characteristic
Returns on
Line for Imperial
Imperial
Tobacco
Tobacco %
• High alpha
• R-square is very
low ≈ 0.02
• Beta is largely
irrelevant
Returns on
the Market %
(S&P TSX)
Characteristic
Returns on
Line for GM
General
Motors % (high R2)
• Positive alpha
• R-square is
very high ≈ 0.9
• Beta is positive
and close to 1.0
Returns on
the Market %
(S&P TSX)
Returns on
the Market %
(S&P TSX)
Process:
– Go to http://ca.finance.yahoo.com
– Use the symbol lookup function to search for the
company you are interested in studying.
– Use the historical quotes button…and get 30 months
of historical data.
– Use the download in spreadsheet format feature to
save the data to your hard drive.
Volume of
Opening price per share, the trading done
The day, highest price per share during the in the stock on
month and month, the lowest price per share the TSE in the
year achieved during the month and the month in
closing price per share at the end numbers of
of the
CHAPTER month
9 – The Capital Asset Pricing Model (CAPM) board 9lots
- 113
Spreadsheet Data From Yahoo
Alcan Example
From Yahoo, the only information you can use is the closing price per
share and the date. Just delete the other columns.
Date Close
01-May-02 59.22
01-Apr-02 57.9
01-Mar-02 63.03
01-Feb-02 64.86
02-Jan-02 61.85
In addition to the closing price of the stock on a per share basis, you will need
to find out how many shares were outstanding at the end of the month and
whether any dividends were paid during the month.
You will also want to find the end-of-the-month value of the S&P/TSX Total
Return Composite Index (look in the green pages of the TSX Review)
Closing
Price for Cash
Issued Alcan Dividends Adjustment Normalized Normalized
Date Capital AL.TO per Share Factor Stock Price Dividend
01-May-02 321,400,589 $59.22 $0.00 1.00 $59.22 $0.00
01-Apr-02 321,400,589 $57.90 $0.15 1.00 $57.90 $0.15
01-Mar-02 321,400,589 $63.03 $0.00 1.00 $63.03 $0.00
01-Feb-02 321,400,589 $64.86 $0.00 1.00 $64.86 $0.00
02-Jan-02 160,700,295 $123.70 $0.30 0.50 $61.85 $0.15
01-Dec-01 145,000,500 $111.40 $0.00 0.45 $50.26 $0.00
Normalized Normalized ( P1 P0 ) D1
HPR
Date Stock Price Dividend HPR P0
01-May-02 $59.22 $0.00 2.28% $59.22 - $57.90 $0.00
$57.90
01-Apr-02 $57.90 $0.15 -7.90%
2.28%
01-Mar-02 $63.03 $0.00 -2.82%
01-Feb-02 $64.86 $0.00 4.87%
02-Jan-02 $61.85 $0.15 23.36%
01-Dec-01 $50.26 $0.00
Ending
Normalized Normalized TSX
Date Stock Price Dividend HPR Value
01-May-02 $59.22 $0.00 2.28% 16911.33
01-Apr-02 $57.90 $0.15 -7.90% 16903.36
01-Mar-02 $63.03 $0.00 -2.82% 17308.41
01-Feb-02 $64.86 $0.00 4.87% 16801.82
02-Jan-02 $61.85 $0.15 23.36% 16908.11
01-Dec-01 $50.26 $0.00 16881.75
( P1 P0 )
HPR
P0
16,911.33 - 16,903.36
Ending
Normalized Normalized 16,903.36 TSX HPR on
0.05%
Date Stock Price Dividend HPR Value the TSX
01-May-02 $59.22 $0.00 2.28% 16911.33 0.05%
01-Apr-02 $57.90 $0.15 -7.90% 16903.36 -2.34%
01-Mar-02 $63.03 $0.00 -2.82% 17308.41 3.02%
01-Feb-02 $64.86 $0.00 4.87% 16801.82 -0.63%
02-Jan-02 $61.85 $0.15 23.36% 16908.11 0.16%
01-Dec-01 $50.26 $0.00 16881.75
Ending
Normalized Normalized TSX HPR on
Date Stock Price Dividend HPR Value the TSX
01-May-02 $59.22 $0.00 2.28% 16911.33 0.05%
01-Apr-02 $57.90 $0.15 -7.90% 16903.36 -2.34%
01-Mar-02 $63.03 $0.00 -2.82% 17308.41 3.02%
01-Feb-02 $64.86 $0.00 4.87% 16801.82 -0.63%
02-Jan-02 $61.85 $0.15 23.36% 16908.11 0.16%
01-Dec-01 $50.26 $0.00 16881.75
The dependent
independentvariable
variableis isthe
thereturns
returnsononthe
theStock.
Market.
CoefficientsStandard Error t Stat P-value Lower 95% Upper 95% Lower 95.0%Upper 95.0%
Intercept 59.3420816 2.8980481 20.4765686 3.3593E-05 51.29579335 67.38836984 51.2957934 67.38837
X Variable 1 3.55278937 33.463777 0.10616821 0.920560274 -89.35774428 96.46332302 -89.3577443 96.46332
• You can use the charting feature in Excel to create a scatter plot of
the points and to put a line of best fit (the characteristic line) through
the points.
• In Excel, you can edit the chart after it is created by placing the
cursor over the chart and ‘right-clicking’ your mouse.
• In this edit mode, you can ask it to add a trendline (regression line)
• Finally, you will want to interpret the Beta (X-coefficient) the alpha
(vertical intercept) and the coefficient of determination.