Chapter 9: The Capital Asset Pricing Model (CAPM

-This chapter is a continuation of Ch. 8 9.1 The New Efficient Frontier - Portfolios of risky securities that lie along the efficient frontier dominate all other possible portfolios of risky securities. - In considering how investors pick securities, we assume that investors are risk averse (i.e. they will not willingly undertake fair gambles). - Therefore, a risk-averse person needs a risk premium or an insurance premium (a payment to get out of a risky situation) - See Figure 9.1 for a picture of the efficient frontier. - Many lines go through the origin and touch different points on the efficient frontier. - The flatter the lines, the less risk averse are the investors. - Apart from knowing that investors differ in terms of their risk aversion, we know only that their preferred portfolio will lie somewhere along the efficient frontier. Risk-Free Investing ERp = RF + w(ERa RF) -The expected return on the portfolio = Tbill + weight of risky asset(expected return of the risky asset Tbill) STDEVp = w(STDEVa) -This equation is important as it shows that portfolio risk increases in direct proportion to the amount invested in the risky asset. The higher the allocation the higher the risk. -If we solve for w to get w = STDEVp/STDEVa - Then substitute into the first equation we get: E(Rp) = RF + [ E(Ra) RF/STDEVa ] STDEVp -This is the equation of a straight line. -It indicates that the line touches the vertical axis at the risk-free rate and then has a constant slope. -The slope is the increased expected return divided by the increased risk. See Figure 9.2, 9.3 & 9.4 Efficient Portfolios -The Tangent Portfolio is the risky portfolio on the efficient frontier whose tangent line cuts the vertical axis at the risk-free rate. -New (or super) Efficient Frontier portfolios composed of the risk-free rate and the tangent portfolio offer the highest expected rate of return for any given level of risk. See Example 9-1: To calculate the Expected Return and STDEV for a 2 Asset portfolio that includes investment in a risk-free Asset. Risk Free Borrowing -Less risk averse investors can borrow to be able to be more than 100% invested in the risky portfolio. This is called a negative or short position, where the investor borrows part of the purchase price for the stockbroker (i.e. on margin). 1

See Example 9-2: To calculate the Expected Return and STDEV for a 2 Asset portfolio that includes borrowing at the risk-free rate. The New Efficient Set and the Separation Theorem: -Investing and borrowing has expanded the efficient set and provided investors with a more efficient set of portfolio from which to choose. -Investors can now choose the point on this line that suits their risk preference. -Separation Theorem: the theory that the investment decision (how to construct the portfolio of risky assets) is separate from the financing decision (how much should be invested or borrowed in the risk-free asset). 9.2 The Capital Asset Pricing Model -CAPM is a pricing model that uses one factor, beta, to relate expected returns to risk. - The development of CAPM was based on a number of assumptions: 1. All investors have identical expectations about expected returns, standard deviations, and correlation coefficients for all securities. 2. All investors have the same one-period time horizon. 3. All investors can borrow or lend money at the risk-free rate of return. 4. There are no transaction costs. 5. There are no personal income taxes so that investors are indifferent between capital gains and dividends. 6. There are many investors, and no single investor can affect the price of a stock through their buying or selling decisions. Therefore, investors are price takers. 7. Capital markets are in equilibrium. -These assumptions may appear unrealistic at first, but not all investors matter, the most important are the big institutions that invest most of the money. -CAPM has important implications: 1. The optimal risk portfolio is the one that is tangent to the efficient frontier on a line that is drawn from RF, this portfolio will be the same for all investors. 2. This optimal risky portfolio will be the market portfolio (M), which contains all risky securities. The value of this portfolio will equal the aggregate of the market values of all the individual assets composing it. -The Capital Market Line (CML) is the line depicting the highest attainable expected return for any given risk level that includes only efficient portfolios; all rational, riskaverse investors want to be on this line. Slope of the CML = ERm RF / STDDEVm -Market Price of Risk is the incremental expected return divided by the incremental risk. This indicates the additional expected return that the market demands for an increase in risk. -The CML indicates an expected rate of return. -The Required Rate of Return is the rate of return investors need to tempt them to invest in a security. -All portfolios should lie along the CML, as those offering higher expected than required rates of return have their prices bid up and vice versa. -See Example 9.3 to learn how to calculate the required rate of return using CML. 2

-Sharpe Ratio is a measure of portfolio performance that describes how well an assets return compensates investors for the risk taken. Sharpe Ratio = ERp RF / STDEVp 9.3 The CAPM and Market Risk -As the number of securities included in a portfolio increases, unique (non-systematic or diversifiable) risk is eliminated, and only market (systematic or non-diversifiable) risk remains. -Therefore, by randomly building diversified portfolios, the risk of a portfolio falls, until it reaches a baseline and cannot be reduced below this market level. -Beta is a measure of market risk, or performance volatility, that relates the extent to which the return on a security moves with that of the overall market, the covariance between an investment and the market divided by variances of the market. Beta = (Covariance between an investment and the market) / (standard deviation of the market) -Typically, betas are estimated by using 60 months of monthly returns, but sometimes 52 weeks of weekly returns are used. -The risk-free asset has a beta of 0, because it has a covariance of 0 with the market and has no risk. -Unlike portfolio standard deviations, portfolio betas are weighted averages of the betas for the individual securities in the portfolio. -Characteristic Line is a line of best fit (regression line) through the returns on an individual security, plotted on the vertical axis, relative to the returns of the market, plotted along the horizontal axis. See Example 9.4 on how to estimate beta. The Security Market Line (SML) -Based on the argument made earlier that investors should be compensated for market risk, as measured by beta, it is easy to use the CML to derive the SML. Ki = RF + (ERm) RF)Beta -The SML is the most important and widely used contribution of the CAPM. -According to the SML, securities or portfolios with betas greater than the market beta of 1.0 will have larger risk premiums than the average stock and will therefore have larger required rates of return. -Market Risk Premium is the risk premium as a function of market conditions; the expected return on the market minus the risk-free rate. ER RF = Premium The SML and Security Valuation -In equilibrium, the expected return on all properly priced securities will lie on the SML. - Same as the expected return on all portfolios will lie on the CML. -When investors expect a return equal to the required return, the security is correctly priced. 3

9.4 Alternative Asset Pricing Models -The CAPM is a single factor model, because it suggests that the required return on equities is determined by only one risk factor: MARKET RISK. -CAPM is often critized because it is based on several assumptions, many of which are called into question in the real world. Empirical evidence also finds that the CAPM doesnt hold well in practice. -Specifically, Richard Roll argued that the CAPM cannot be tested empirically because the market portfolio, which consists of all risky assets, is unobservable. Therefore, researchers are forced to use market proxies, which may or may not be the optimal meanvariance efficient portfolios. -Despite the criticisms of the CAPM, it remains the most commonly used method of estimating the required rate of return on individual securities. -Alternative asset pricing models have been developed, two of the better-known alternatives include the Fama-French Model and the Arbitrage Pricing Theory. These are both multi-factor models, because they assume that more than one factor affects stock price. -Fama-French Model is a pricing model that uses three factors (a market factor, the market value of a firms common equity, and the ratio of a firms book equity value to its market value of equity) to relate expected returns to risk. -Arbitrage Pricing Theory (APT) is a pricing model that uses multiple factors to relate expected returns to risk by assuming that asset returns are linearly related to a set of indexes, which proxy risk factors that influence security returns. ER = a + b1F1 + b2F2 . b = sensitivity to a given risk factor F = risk premium for a given risk factor. This is basically the CAPM, with multiple factors. The main problem is that the factors are not specified ahead of time and does not have a specified number of risk factors. Roll and Ross identify the following five systematic factors: o Changes in expected inflation o Unanticipated changes in inflation o Unanticipated changes in industrial production o Unanticipated changes in the default-risk premium (long-term corporate bonds minus long-term government bonds). o Unanticipated changes in the term structure of interest rates.