Corporate Finance

Lecture 7

Corporate Finance
Lecture 7 :
Capital Asset Pricing Model
(CAPM)

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Capital Asset Pricing Model

! Assumptions
! To minimise risk, investors are risk averse
=> Hold diversified portfolios
Unsystematic risk eliminated through portfolio
diversification
Only risk that investors are sensitive to is systematic risk
! Existence of risk free assets earning Rf : Unlimited lending
& borrowing possible

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Corporate Finance

Lecture 7

Capital Asset Pricing Model

!

!
!
!
!
!

Investors are price takers & have homogeneous

expectations about asset returns
Perfect market (i.e. no taxes & transaction costs) &
information
Investors are rational ie. maximising return relative to risk
measured by variance
All investors have single-period planning horizon
Capital markets are in equilibrium
All investments are infinitely divisible

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Capital Asset Pricing Model

! Provides measure for systematic risk of a securitys return
relative to the overall markets return
! reflects the sensitivity of a securitys return relative to
markets return
!

= 1 : Return on security tend to move with market

proportionately

> 1 : High level of systematic risk & security is very

sensitive to market changes
=> Aggressive security

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Corporate Finance

Lecture 7

Capital Asset Pricing Model

!

< 1 : Low level of systematic risk & security is less

sensitive to market changes
=> Defensive security

Example
Assuming x = 1.5
An overall increase in market return of 5%
=> Security Xs return should increase by a multiple of 1.5
i.e. 7.5%
Conversely, if market return falls by 5%
=> Security Xs return should fall by 7.5%
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Capital Asset Pricing Model

! CAPM defines risk premium on a security as :
Rp = x (Rm - Rf )
where RP = Risk premium
Rm = Market return
Rf = Risk-free return
=> RP varies directly with or systematic risk
! RP enable an investor to determine the required return for a
given level of risk

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Corporate Finance

Lecture 7

Security Market Line

! The risk-return tradeoff relationship can be represented by
the Security Market Line (SML)
! Constructing the Security Market Line
! If of a security is zero : No systematic risk
=> Can earn Rf risk-free return
! Based on historical return, we are able to determine the
average market return (Rm) for = 1
! Join the 2 points gives the SML equation as
! Required Return on Risky Asset X (Rx)= Rf + [x(Rm - Rf)]

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Security Market Line under CAPM

E(R)

SML
Rm

Rf

0.5

1.0

Beta

Rx = Rf + x(Rm - Rf)
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Corporate Finance

Lecture 7

Security Market Line (SML)

! SML expresses the linear relationship between
! The expected returns on a risky asset &
! Its covariance with the market returns
! For individual risky asset, the relevant risk measure is its
covariance with the market portfolio [Cov(Ri,Rm)]
! Beta () coefficient is an alternative way to represent the
covariance of a security with the market

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Security Market Line (SML)

! Beta () of a portfolio is the weighted average of the betas of

its component securities given as follows :

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Corporate Finance

Lecture 7

Empirical Evidence of SML

! Strong relationship between expected return & beta or risk
BUT not as stable as predicted by SML
! SML represents excess return (Rm - Rf) as an increasing
function of beta BUT in reality, the slope is less (as per Black,
Jensen & Scholes Test)
! Lower beta securities earn higher return than suggested by
SML
! Higher beta securities earn lower return than suggested by
SML

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Black, Jensen & Scholess Test of CAPM

Average Annual
Return

Theoretical SML line

15.5%
Fitted SML line
(Empirical Evidence)

Rm = 12%
8.5%
Rf = 5%
0

0.5

1.0

1.5

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2.0

Beta

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Corporate Finance

Lecture 7

Empirical Tests of CAPM

! Other empirical tests also question the validity that is the
only factor that cause expected returns to differ as other
factors have been found to have an effect on expected returns
of a security or portfolio such as firm size, book to market
ratios, PE ratios, dividend yields etc
! CAPM may be an oversimplification of risk factors affecting a
securitys expected return based on a composite risk factor
represented by
! represent a historical co-variance of price/return movements
relative to the market portfolio in response to all market risks

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Rolls Critique of CAPM

! Basic premise of CAPM
!
!
!

Market portfolio is mean-variance efficient

Does not mean that market portfolio is risk free
Market portfolio has a risk level equivalent to = 1 that
commensurate with Rm

! Rolls critique focus on composition of market portfolio

! Researchers generally use a broad-based equity index such
as the FTSE-100, S&P-500, Nikkei 225 or ST Industrial
Index to proxy the market

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Corporate Finance

Lecture 7

Rolls Critique of CAPM

!

True market investment portfolio should include other

financial assets (e.g. bonds) as well as non-financial
assets (e.g. real estate)
Conclusions of Rolls Critique
If Market Portfolio is not observable -> CAPM is not
testable
2 sub-arguments
Actual market portfolio may be efficient but the
chosen proxy for the market may not be efficient
Proxy market may be efficient but not the actual
market portfolio
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Rolls Critique of CAPM

Hence, if we cant guarantee the quality of our proxy for
the market, it would imply that we cant place any faith
in the results
! Some empirical tests have focused on whether the expected
excess return of a given security or portfolio over the Rf is
linearly related to the market risk premium (Rm - Rf)

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Corporate Finance

Lecture 7

Market Risk Approach

! Systematic or Market Risk Approach (CAPM)
! Determine portfolio p
p = WA A + WB B
!

Determine portfolio expected return E(RP)

E(RP) = WA RA + WB RB

Another way to determine expected return E(RP)

E(RP) = Rf + p(Rm - Rf)

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Market Risk Approach

where
WA, WB = Proportions of funds invested in security A & B
A, B = Beta risk of each security A & B
RA, RB = Required rate of return for security A & B
RA = Rf + A (Rm - Rf)
RB = Rf + B (Rm - Rf)

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Corporate Finance

Lecture 7

Market Risk Approach - Example

Example on a 2-Asset Portfolio
Security A has a A of 1.50 while Security B has a B of 1.10
Rf = 5%
Rm = 12%
Assuming WA = WB = 0.50
P = (0.50)(1.50) + (0.50)(1.10) = 0.75 + 0.55 = 1.30
E(RP) = 5% + 1.30(12% - 5%) = 14.10%
Alternatively
RA = 5% + 1.50(12% - 5%) = 15.50%
RB = 5% + 1.10(12% - 5%) = 12.70%
E(RP) = (0.50)(15.50%) + (0.50)(12.70%) = 14.10%
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