The Capital Asset Pricing
Model (CAPM)
Chapter 10
Individual Securities
The characteristics of individual securities
that are of interest are the:
Expected Return
Variance and Standard Deviation
Covariance and Correlation
Expected Return, Variance, and Covari-
ance
Rate of Return
Scenario Probability Stock fund Bond fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%
Consider the following two risky asset
world. There is a 1/3 chance of each state of
the economy and the only assets are a
stock fund and a bond fund.
Expected Return, Variance, and Covari-
ance
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
Expected Return, Variance, and Covari-
ance
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
E (rS ) 1 (7%) 1 (12%) 1 (28%)
3 3 3
E (rS ) 11 %
Expected Return, Variance, and Covari-
ance
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
E (rB ) 1 (17%) 1 (7%) 1 (3%)
3 3 3
E (rB ) 7%
Expected Return, Variance, and Covari-
ance
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
(7% 11 %) 3.24%
2
Expected Return, Variance, and Covari-
ance
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
(12% 11 %) .01%
2
10.2 Expected Return, Variance, and Co-
variance
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
1
2.05% (3.24% 0.01% 2.89%) 14.3% 0.0205
3
The Return and Risk for Portfolios
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
Note that stocks have a higher expected return than bonds
and higher risk. Let us turn now to the risk-return tradeoff
of a portfolio that is 50% invested in bonds and 50% in-
vested in stocks.
The Return and Risk for Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Expected return 11.00% 7.00% 9.0%
Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
The rate of return on the portfolio is a weighted average of
the returns on the stocks and bonds in the portfolio:
rP wB rB wS rS
5% 50% (7%) 50% (17%)
The Return and Risk for Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Expected return 11.00% 7.00% 9.0%
Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
The expected rate of return on the portfolio is a weighted
average of the expected returns on the securities in the
portfolio. E (rP ) wB E (rB ) wS E (rS )
9% 50% (11 %) 50% (7%)
The Return and Risk for Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Expected return 11.00% 7.00% 9.0%
Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
The variance of the rate of return on the two risky assets
portfolio is
σ P2 (wB σ B ) 2 (wS σ S ) 2 2(wB σ B )(wS σ S )ρ BS
where BS is the correlation coefficient between the returns
on the stock and bond funds.
10.3 The Return and Risk for Portfo-
lios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Expected return 11.00% 7.00% 9.0%
Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
Observe the decrease in risk that diversification offers.
An equally weighted portfolio (50% in stocks and 50%
in bonds) has less risk than stocks or bonds held in iso-
lation.
10.4 The Efficient Set for Two Assets
% in stocks Risk Return Portfolo Risk and Return Combinations
0% 8.2% 7.0%
5% 7.0% 7.2% 12.0%
Portfolio Return
10% 5.9% 7.4% 11.0%
15% 4.8% 7.6% 10.0% 100%
20% 3.7% 7.8% 9.0% stocks
25% 2.6% 8.0% 8.0%
30% 1.4% 8.2% 7.0%
35% 0.4% 8.4% 100%
6.0%
40% 0.9% 8.6% bonds
5.0%
45% 2.0% 8.8%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
50.00% 3.08% 9.00%
55% 4.2% 9.2% Portfolio Risk (standard deviation)
60% 5.3% 9.4%
65%
70%
6.4%
7.6%
9.6%
9.8%
We can consider other portfo-
75% 8.7% 10.0% lio weights besides 50% in
80% 9.8% 10.2%
85% 10.9% 10.4% stocks and 50% in bonds …
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
10.4 The Efficient Set for Two Assets
% in stocks Risk Return Portfolo Risk and Return Combinations
0% 8.2% 7.0%
5% 7.0% 7.2% 12.0%
Portfolio Return
10% 5.9% 7.4% 11.0%
15% 4.8% 7.6% 10.0% 100%
20% 3.7% 7.8% 9.0% stocks
25% 2.6% 8.0% 8.0%
30% 1.4% 8.2% 7.0% 100%
35% 0.4% 8.4% 6.0% bonds
40% 0.9% 8.6% 5.0%
45% 2.0% 8.8% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
50% 3.1% 9.0%
55% 4.2% 9.2% Portfolio Risk (standard deviation)
60% 5.3% 9.4%
65% 6.4% 9.6% Note that some portfolios are
70%
75%
7.6%
8.7%
9.8%
10.0%
“better” than others. They have
80% 9.8% 10.2% higher returns for the same level
85% 10.9% 10.4%
90% 12.1% 10.6%
of risk or less.
95% 13.2% 10.8%
100% 14.3% 11.0%
Two-Security Portfolios with Various Correla-
tions
return
100%
= -1.0 stocks
= 1.0
100%
= 0.2
bonds
Portfolio Risk/Return Two Securities: Cor-
relation Effects
Relationship depends on correlation coeffi-
cient
-1.0 < r < +1.0
The smaller the correlation, the greater the
risk reduction potential
If r = +1.0, no risk reduction is possible
The Efficient Set for Many Securities
return
Individual Assets
P
Consider a world with many risky assets; we
can still identify the opportunity set of risk-re-
turn combinations of various portfolios.
The Efficient Set for Many Securities
return minimum
variance
portfolio
Individual Assets
P
Given the opportunity set we can identify the
minimum variance portfolio.
The Efficient Set for Many Securities
return
ontier
r
i ent f
c
effi
minimum
variance
portfolio
Individual Assets
P
The section of the opportunity set above the minimum vari-
ance portfolio is the efficient frontier.
Optimal Risky Portfolio with a Risk-Free Asset
return
100%
stocks
rf
100%
bonds
In addition to stocks and bonds, consider a world that
also has risk-free securities like T-bills
Riskless Borrowing and Lending
return
CM 100%
stocks
Balanced
fund
rf
100%
bonds
Now investors can allocate their money across
the T-bills and a balanced mutual fund
The Capital Market Line
Assumptions:
Rational Investors:
More return is preferred to less.
Less risk is preferred to more.
Homogeneous expectations
Riskless borrowing and lending.
σ P2 (wF σ F )2 (wAσ A )2 2(wF σ F )(wAσ A )ρFA P wA A
Riskless Borrowing and Lending
return
L
CM efficient frontier
rf
P
With a risk-free asset available and the efficient
frontier identified, we choose the capital alloca-
tion line with the steepest slope
Market Equilibrium
return
L
CM efficient frontier
rf
P
With the capital allocation line identified, all investors choose a point
along the line—some combination of the risk-free asset and the mar-
ket portfolio M. In a world with homogeneous expectations, M is the
same for all investors.
The Separation Property
return
L
CM efficient frontier
rf
P
The Separation Property states that the market
portfolio, M, is the same for all investors—they can
separate their risk aversion from their choice of the
market portfolio.
The Separation Property
return
L
CM efficient frontier
rf
P
Investor risk aversion is revealed in their
choice of where to stay along the capital al-
location line—not in their choice of the line.
Market Equilibrium
return
CM 100%
stocks
Balanced
fund
rf
100%
bonds
Just where the investor chooses along the Capital Market Line
depends on his risk tolerance. The big point though is that all
investors have the same CML.
Market Equilibrium
return
CM 100%
stocks
Optimal
Risky
Porfolio
rf
100%
bonds
All investors have the same CML because they all have
the same optimal risky portfolio given the risk-free rate.
The Separation Property
return
CM 100%
stocks
Optimal
Risky
Porfolio
rf
100%
bonds
The separation property implies that portfolio choice can
be separated into two tasks: (1) determine the optimal
risky portfolio, and (2) selecting a point on the CML.
Optimal Risky Portfolio with a Risk-Free
Asset
L 0 CML 1
return
CM 100%
stocks
1 First Op- Second Optimal
r f timal Risky Portfolio
0 Risky
r f Portfolio
100%
bonds
The optimal risky portfolio depends on the
risk-free rate as well as the risky assets.
Expected versus Unexpected Returns
Realized returns are generally not equal to
expected returns
There is the expected component and the
unexpected component
At any point in time, the unexpected return can
be either positive or negative
Over time, the average of the unexpected com-
ponent is zero
Returns
Total Return = expected return + unexpected
return
Unexpected return = systematic portion + un-
systematic portion
Therefore, total return can be expressed as
follows:
Total Return = expected return + systematic
portion + unsystematic portion
Total Risk
Total risk = systematic risk + unsystematic
risk
The standard deviation of returns is a mea-
sure of total risk
For well diversified portfolios, unsystematic
risk is very small
Consequently, the total risk for a diversified
portfolio is essentially equivalent to the sys-
tematic risk
Portfolio Risk as a Function of the Number of
Stocks in the Portfolio
In a large portfolio the variance terms are effectively
diversified away, but the covariance terms are not.
Diversifiable Risk; Non-
systematic Risk; Firm
Specific Risk; Unique
Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk; Mar-
ket Risk
n
Thus diversification can eliminate some, but not all of the
risk of individual securities.
Definition of Risk When Investors Hold the
Market Portfolio
The best measure of the risk of a security in a
large portfolio is the beta (b)of the security.
Beta measures the responsiveness of a se-
curity to movements in the market portfolio.
Cov( Ri , RM )
i
( RM )
2
Total versus Systematic Risk
Consider the following information:
Standard Deviation Beta
Security C 20% 1.25
Security K 30% 0.95
Which security has more total risk?
Which security has more systematic risk?
Which security should have the higher ex-
pected return?
Estimating b with regression
Security Returns
i ne
t i cL
ri s
c te
ara
Ch Slope = bi
Return on
market %
Ri = a i + biRm + ei
Beta
Reuters
Yahoo
The Formula for Beta
Cov( Ri , RM )
i
( RM )
2
Your estimate of beta will depend upon your choice of a
proxy for the market portfolio.
Beta of a Portfolio
Stock Amount Portfolio Beta
Invested weights
IBM $6,000 50% 0.90 0.450
GM $4,000 33% 1.10 0.367
Walmart $2,000 17% 1.30 0.217
Portfolio $12,000 100% 1.03
The beta of a portfolio is a weighted average of the
beta’s of the stocks in the portfolio.
Mutual Fund Betas
Relationship of Risk to Reward
The fundamental conclusion is that the ratio of the
risk premium to beta is the same for every asset.
In other words, the reward-to-risk ratio is constant and
equal to:
E ( Ri ) RF
Re ward / Risk
i
Market Equilibrium
In equilibrium, all assets and portfolios must
have the same reward-to-risk ratio and they
all must equal the reward-to-risk ratio for the
market
E ( RA ) R f E ( RM ) R f
A M
Relationship between Risk and Expected Return
(CAPM)
Expected Return on the Market:
R M RF Market Risk Premium
• Expected return on an individual security:
R i RF β i ( R M RF )
Market Risk Premium
This applies to individual securities held within well-diversified
portfolios.
Expected Return on an Individual Secu-
rity
This formula is called the Capital Asset
Pricing Model (CAPM)
R i RF β i ( R M RF )
Expected
Risk- Beta of the Market risk
return on = + ×
free rate security premium
a security
• Assume b = 0, then the expected return is R .
i F
• Assume b = 1, then R i R M
i
Relationship Between Risk & Expected
Return
Expected return R i RF β i ( R M RF )
RM
RF
1.0 b
The slope of the security market line is equal to the market
risk premium; i.e., the reward for bearing an average amount
of systematic risk.
Relationship Between Risk & Expected
Expected re-
Return
turn
13.5%
β i 1. 5 3%
R F 3%
1.5 b
R M 10%
R i 3% 1.5 (10% 3%) 13.5%
Total versus Systematic Risk
Consider the following information:
Standard Deviation Beta
Security C 20% 1.25
Security K 30% 0.95
Which security has more total risk?
Which security has more systematic risk?
Which security should have the higher ex-
pected return?
Summary and Conclusions
This chapter sets forth the principles of modern portfolio
theory.
The expected return and variance on a portfolio of two
securities A and B are given by
E (rP ) wA E (rA ) wB E (rB )
σ P2 (wAσ A )2 (wB σ B )2 2(wB σ B )(wAσ A )ρ AB
• By varying wA, one can trace out the efficient set of portfolios. We
graphed the efficient set for the two-asset case as a curve, pointing out
that the degree of curvature reflects the diversification effect: the lower
the correlation between the two securities, the greater the diversification.
• The same general shape holds in a world of many assets.
Summary and Conclusions
The efficient set of risky assets can be combined with
riskless borrowing and lending. In this case, a rational
investor will always choose to hold the portfolio of risky
securities represented by the market portfolio.
return
L
• Then with borrow- CM efficient frontier
ing or lending, the
investor selects a M
point along the
CML. rf
P
Summary and Conclusions
The contribution of a security to the risk of a well-diversi-
fied portfolio is proportional to the covariance of the se-
curity's return with the market’s return. This contribution
is called the beta.
Cov( Ri , RM )
i
2 ( RM )
• The CAPM states that the expected return on a security is
positively related to the security’s beta:
R i RF β i ( R M RF )
Expected (Ex-ante) Return, Variance and
Covariance
Expected Return: E(R) = S (ps x Rs)
Variance: s2 = S {ps x [Rs - E(R)]2}
Standard Deviation = s
Covariance: sAB = S {ps x [Rs,A - E(RA)] x [Rs,B -
E(RB)]}
Correlation Coefficient: rAB = sAB / (sA sB)
Risk and Return Example
State Prob. T-Bills IBM HM XYZ Market
Port.
Recession 0.05 8.0% (22.0%) 28.0% 10.0% (13.0%)
Below Avg.0.20 8.0 (2.0) 14.7 (10.0) 1.0
Average 0.50 8.0 20.0 0.0 7.0 15.0
Above Avg. 0.20 8.0 35.0 (10.0) 45.0 29.0
Boom 0.05 8.0 50.0 (20.0) 30.0 43.0
E(R)=
s =
Expected Return and Risk of IBM
E(RIBM)= 0.05*(-22)+0.20*(-2)
+0.50*(20)+0.20*(35)+0.05*(50) = 18%
sIBM2 = 0.05*(-22-18)2+0.20*(-2-18)2
+0.50*(20-18)2+0.20*(35-18)2
+0.05*(5018)2 = 271
sIBM =16.5%
Covariance and Correlation
COV IBM&XYZ = 0.05*(-22-18)(10-12.5)+
0.20*(-2-18)(-10-12.5)+0.50*(20-18)(7-12.5)+
0.20*(35-18)(45-12.5)+0.05*(50-18)(30-12.5)
=194
Correlation = 194/(16.5)(18.5)=.6355
Risk and Return for Portfolios (2 assets)
Expected Return of a Portfolio:
E(Rp) = XAE(R)A + XB E(R)B
Variance of a Portfolio:
sp2 = XA2sA2 + XB2sB2 + 2 XA XB sAB
