The Capital Asset Pricing Model (CAPM)

 The CAPM
 The market portfolio
 The capital market line
 The risk premium on the market portfolio
 Expected returns on individual securities
 The security market line
 Liquidity and the CAPM

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 The CAPM

 An equilibrium model specifying the

relationship between risk and expected
return on risky assets.

 Assumptions:
• Investors are price-takers (i.e. their trades do
not affect security prices).
• Investors have a single-period investment
horizon.

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• Investments are limited to publicly traded
financial assets (e.g. stocks & bonds), and to
risk-free borrowing or lending
arrangements.
• Investors pay no taxes on returns and no
transaction costs (commissions and service
charges) on trades in securities.
• All investors are rational mean-variance
optimizers.
• All investors have the same expectations (i.e.
identical estimates of expected returns,
variances, and covariances among all assets). 3
 Model implication 1: The market portfolio

 All investors will choose to hold a portfolio

of risky assets in proportions that duplicate
representation of the assets in the market
portfolio (M), which includes all traded
assets.

The proportion of each asset in the market

portfolio equals the market value of the
asset divided by the total market value of all
assets.
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 Why?

All investors arrive at the same

determination of the optimal risky
portfolio, the portfolio on the efficient
frontier identified by the tangency line
from T-bills to that frontier.

As a result, the optimal risky portfolio of all

investors is simply the market portfolio.

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 Model implication 2: The capital market line (CML)
 Not only will the market portfolio be on the
efficient frontier, but it also will be the
tangency portfolio to the optimal capital allocation
line (CAL) derived by every investor.
As a result, the capital market line (CML), the line
from the risk-free rate through the market
portfolio, M, is also the best attainable capital
allocation line.
All investors hold M as their optimal risky
portfolio, differing only in the amount invested in it
versus in the risk-free asset. 7
 Mutual fund theorem:
Since all investors choose to hold a market index
mutual fund, we can separate portfolio selection
into 2 components:
• a technological problem: creation of market index
mutual funds by professional managers;
• a personal problem: depends on an investor’s risk
aversion, allocation of the complete portfolio
between the mutual fund and risk-free assets.
Note: In reality, different investment managers do
create risky portfolios that differ from the market
index (in part due to the use of different input lists
in the formation of the optimal risky portfolio). 8
 Model implication 3: Risk premium on M
 The risk premium on the market portfolio will be
proportional to its risk and the degree of risk
aversion of the representative investor:

where
E(rM): expected return on M
: variance of M
: average degree of risk aversion across
investors
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 Recall: Each individual investor chooses a
proportion y, allocated to the optimal portfolio M,
such that:

Risk-free investments involve borrowing and

lending among investors. Any borrowing position
must be offset by the lending position of the
creditor. This means that net borrowing and
lending across all investors must be zero, and thus
the average position in the risky portfolio is 100%,
or y = 1.
Setting y = 1 and rearranging, we obtain the risk
premium on the market portfolio. 10
 Model implication 4:
Expected returns on individual securities
 The contribution of an asset to the risk of the
market portfolio:

Risk-averse investors measure the risk of the

optimal risky portfolio (i.e. the market
portfolio) by its variance.

We would expect the reward, or the risk

premium on individual assets, to depend on
the contribution of the individual asset to the
variance of the market portfolio. 11
To calculate the variance of the market portfolio,
we use the following bordered covariance matrix
with the market portfolio weights:

Portfoli
　 　 　　 　 　　 　
o
Weights w1 w2 . . wGE . . wn
w1 Cov(r1,r1) Cov(r1,r2) . . Cov(r1,rGE) . . Cov(r1,rn)
w2 Cov(r2,r1) Cov(r2,r2) . . Cov(r2,rGE) . . Cov(r2,rn)
. . . . . . . . .
. . . . . . . . .
wGE Cov(rGE,r1) Cov(rGE,r2) . . Cov(rGE,rGE) . . Cov(rGE,rn)
. . . . . . . . .
. . . . . . . . .
wn Cov(rn,r1) Cov(rn,r2) . . Cov(rn,rGE) . . Cov(rn,rn)
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The contribution of GE’s stock to the variance of
the market portfolio:

The covariance of GE with the market portfolio

is proportional to the contribution of GE to the
variance of the market portfolio.
In other words, we can measure an asset’s
contribution to the risk of the market portfolio
by its covariance with the market portfolio.
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• The reward-to-risk ratio for investments in GE:

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 The market portfolio has a risk premium of E(rM)
- rf and a variance of , for a reward-to-risk
ratio of:

This ratio is called the market price of risk,

because it quantifies the extra return that
investors demand to bear portfolio risk (i.e. tells
us how much extra return must be earned per
unit of portfolio risk).

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 In equilibrium, all investments should offer the
same reward-to-risk ratio.

If the ratio were better for one investment than

another, investors would rearrange their
portfolios, tilting toward the alternative with the
better trade-off and shying from the other.

Such activity would impact on security prices

until the ratios were equalized.

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In equilibrium, the reward-to-risk ratio of GE
stock must equal that of the market portfolio.
Otherwise, if the reward-to-risk ratio of GE >
the market’s, investors can increase their
portfolio reward for bearing risk by increasing
the weight of GE in their portfolio.
Until the price of GE stock rises relative to the
market, investors will keep buying GE stock.
The process will continue until stock prices
adjust so that reward-to-risk ratio of GE equals
that of the market.
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 The same process, in reverse, will equalize
reward-to-risk ratios when GE’s initial reward-
to-risk ratio < that of the market portfolio.

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 The ratio measures the
contribution of GE stock to the variance of the
market portfolio as a fraction of the total
variance of the market portfolio.

The ratio is called beta and is denoted by .

 The expected return-beta relationship:

More generally, for any asset i:

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 Note: Risk-averse investors measure the risk of the
optimal risky portfolio by its variance. We would
expect the reward (the risk premium on individual
assets) to depend on the contribution of the individual
asset to the risk of the portfolio.
The beta of an asset measures the asset’s contribution
to the variance of the market portfolio as a fraction of
the total variance of the market portfolio. Hence we
expect, for any asset, the required risk premium to be
a function of beta.
The CAPM confirms this intuition: the security’s risk
premium is directly proportional to both the beta &
the risk premium of the market portfolio; that is, the
risk premium equals . 20
 If the expected return-beta relationship holds for any
individual asset, it must hold for any combination of
assets.
Suppose that some portfolio P has weight wk for stock
k, where k takes on values 1, …, n.

Then:

where E(rP)
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 This result has to be true for the market portfolio
itself:

Note:

Þ The market beta (i.e. the weighted average beta of

all assets) is 1.
Þ Betas > 1 are considered aggressive in that
investment in high-beta assets entails above-
average sensitivity to market swings.
Betas < 1 can be described as defensive.
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 Model implication 5:
The security market line (SML)

 The expected return-beta relationship can

be portrayed graphically as the security
market line (SML).
Because the market beta is 1, the slope is
the risk premium of the market portfolio.

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M

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 Compare SML to CML

 The CML graphs the risk premiums of

efficient portfolios (i.e., portfolios composed
of the market and the risk-free asset) as a
function of portfolio standard deviation.

This is appropriate because standard

deviation is a valid measure of risk for
efficiently diversified portfolios that are
candidates for an investor’s overall
portfolio.
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 The SML, in contrast, graphs individual asset
risk premiums as a function of asset risk.

The relevant measure of risk for individual

assets held as parts of well-diversified portfolios
is not the asset’s standard deviation or variance.

It is, instead, the contribution of the asset to the

portfolio variance, which we measure by the
asset’s beta.

The SML is valid for both efficient portfolios

and individual assets.
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 Uses of the SML
 The SML provides a benchmark for the
evaluation of investment performance.
Given the risk of an investment, as measured by
its beta, the SML provides the required rate of
return necessary to compensate investors for risk.
Because the SML is the graphic representation of
the expected return-beta relationship, “fairly
priced” assets plot exactly on the SML; that is,
their expected returns are commensurate with
their risk.
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 The difference between the fair and actually
expected rates of return on an asset is called the
asset’s alpha, denoted .

e.g. The market return is expected to be 14%, a

stock has a beta of 1.2, and the T-bill rate is 6%.
The SML would predict an expected return on the
stock of 6 + 1.2(14 – 6) = 15.6%.
If one believed the stock would provide an
expected return of 17%, the implied alpha would
be 1.4% (= 17% - 15.6%).
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 The CAPM is also useful in capital budgeting
decisions.

For a firm considering a new project, the CAPM

can provide the required rate of return that the
project needs to yield, based on its beta, to be
acceptable to investors.

Managers can use the CAPM to obtain this cutoff

internal rate of return (IRR), or “hurdle rate” for
the project.

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Q: The risk-free rate is 6% and the expected return
on the market portfolio is 14%.

A firm considers a project that is expected to

have a beta of 0.6.

a. What is the required rate of return on the

project?

b. If the expected internal rate of return of the

project is 19%, should it be accepted?

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 The CAPM tells us that an acceptable
expected rate of return for the project is:

which becomes the project’s hurdle rate.

If the internal rate of return of the project is 19%,

then it is desirable.

Any project with an rate of return  10.8% should

be rejected.

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 The CAPM and the Index Model
Recall:
For any asset i and the (theoretical) market portfolio,
the CAPM expected return-beta relationship is:

Recall:
The index model (in excess return form):

or
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 From the index model, the covariance between the
returns on stock i and the market index:

Notes:
 We can drop i from the covariance terms because i
is a constant and thus has zero covariance with all
variables.

 The firm-specific or nonsystematic component is

independent of the marketwide or systematic
component (i.e. Cov(ei, RM) = 0).
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

 The index model beta coefficient turns out to be the

same beta as that of the CAPM expected return-beta
relationship, except that we replace the (theoretical)
market portfolio of the CAPM with the well-specified
and observable market index.

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 If the index M in the index model represents the true
market portfolio, we can take the expectation of each
side of the index model:

A comparison of the index model relationship to the

CAPM expected return-beta relationship shows that
the CAPM predicts that i should be zero for all
assets.
The alpha of a stock is its expected return in excess of
(or below) the fair expected return as predicted by the
CAPM.
If the stock is fairly priced, its alpha must be zero.
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Thus, if we estimate the index model for several firms,
using the index model as a regression equation, we
should find that the ex post or realized alphas (the
regression intercepts) for the firms in our sample
center around zero.
The CAPM states that the expected value of alpha is
zero for all securities, whereas the index model
representation of the CAPM holds that the realized
value of alpha should average out to zero for a sample
of historical observed returns.

Empirical example:
Burton Malkiel examines the alpha values for a large
number of equity mutual funds.
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The distribution of alphas is roughly bell shaped, with
a mean that is slightly negative but statistically
indistinguishable from zero.

Estimates of individual mutual fund alphas,

1972-1991
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 The market model:
The market model states that the return “surprise”
of any security is proportional to the return surprise
of the market, plus a firm-specific surprise:

If the CAPM is valid:

and

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The market model equation becomes identical to the
index model.

Thus, the terms “index model” and “market model”

are used interchangeably.

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 Liquidity and the CAPM
 Liquidity refers to the cost and ease with which an
asset can be converted into cash (i.e. sold).

Recall one assumption of the CAPM that all trading

is costless. In reality, no security is perfectly liquid, in
that all trades involve some transaction cost.

Investors prefer more liquid assets with lower

transaction costs, so that all else equal, relatively
illiquid assets trade at lower prices (i.e. the expected
return on illiquid assets must be higher). Thus, an
illiquidity premium must be impounded into the price
of each asset.
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 Trading costs:

• Commission.

• Bid-asked spread:
 bid price: the price at which a dealer is
willing to purchase a security.
 asked price: the price at which a dealer will
sell a security.
 bid-asked spread: the difference between a
dealer’s bid and asked price.

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 A simple example:
• Consider a world in which market risk premium is
ignored. Thus, the expected rate of return on all
securities will equal the risk-free rate (rf).

• Assume that there are only two classes of securities:

liquid (L) and illiquid (I).
The liquidation cost cL of a class L stock to an investor
with an investment horizon of h years will reduce the
per-period rate of return by cL/h.

Thus, if you intend to hold a class L security for h

periods, your expected rate of return net of
transaction costs is rf - cL/h. 43
 Class I assets have higher liquidation costs cI that
reduce the per-period return by cI/h, where cI > cL.

Thus, if you intend to hold a class I security for h

periods, your expected rate of return net of
transaction costs is rf - cI/h.

These net rates of return would be inconsistent with a

market in equilibrium, because with equal gross rates
of return (rf) all investors would prefer to invest in
zero-transaction-cost asset (the risk-free asset).
As a result, both class L and class I stock prices must
fall, causing their expected returns to rise until
investors are willing to hold these shares. 44
Suppose, therefore, that each gross return is higher by
some fraction of liquidation cost.

Specifically, assume that the gross expected return on

class L stocks is rf + xcL and that of class I stocks is rf
+ ycI.

The net rate of return on class L stocks to an investor

with a horizon of h:
(rf + xcL) - cL/h = rf + cL(x - 1/h).

The net rate of return on class I stocks:

(rf + ycI) - cI/h = rf + cI(y - 1/h).
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 Now we can determine equilibrium illiquidity
premiums.

For the marginal investor with horizon h, the net

return from class I and L stocks is the same:
rf + cL(x - 1/h) = rf + cI(y - 1/h)

 The expected gross return on illiquid stocks:

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Recall that the expected gross return on class L stocks
is rL = rf + cLx.

Thus, the illiquidity premium of class I versus class L

stocks is:

As expected, equilibrium expected rates of return are

bid up to compensate for transaction costs.

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 If we allow for market risk premium, we would find
that the illiquidity premium is simply additive to the
risk premium of the usual CAPM.
Thus, we can generalize the CAPM expected return-
beta relationship to include a liquidity effect:

where f(ci) is a function of trading costs ci that

measures the effect of the illiquidity premium given
the trading costs of security i.
The usual CAPM equation is modified because each
investor’s optimal portfolio is now affected by
liquidation cost as well as risk-return considerations. 48
 Trading frequency may well vary inversely with
trading costs.

An investor who plans to hold a security for a given

period will calculate the impact of illiquidity costs on
expected rate of return; illiquidity costs will be
amortized over the anticipated holding period.

Investors who trade less frequently thus will be less

affected by high trading costs.

The reduction in the rate of return due to trading

costs is lower, the longer the security is held.

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 Hence, in equilibrium, investors with long holding
periods will, on average, hold more of the illiquid
securities, while short-horizon investors will more
strongly prefer liquid securities.

This “clientele effect” mitigates the effect of the bid-

ask spread for illiquid securities.

The end result is that the illiquidity premium should

increase with the bid-ask spread at a decreasing rate.

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The Relationship Between Illiquidity and
Average Returns

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