Module 3: CAPITAL ASSET PRICING MODEL AND MODERN PORTFOLIO THEORY

THE CAPITAL ASSET PRICING MODEL (CAPM)

INTRODUCTION

CAPM is one of the major developments in modern financial theory widely used in investment analysis. We,
however will not attempt to cover the CAPM in detail in this book. Rather, we simply will use its intuition a basic
principle to explain how risk should be considered in a scenario where stocks and other assets are held in portfolios.
CAPM is discussed in detail in a course in investments.

Thus far in the previous chapter, we have considered the riskiness of assets when they are held in isolation. This is
generally appropriate for small businesses, many real estate investments and capital budgeting projects. However,
the risk of a stock held in a portfolio is typically lower than the stock’s risk when it is held alone. Since investors
dislike risk and since risk can be reduced by holding portfolios, most stocks are held in portfolios. Bank, insurance
companies, pension funds and other financial institution are required by law to hold diversified portfolios.

Capital Asset Pricing Model (CAPM) is a model based on the proposition that any stock’s required rate of return is
equal to the risk- free rate of return plus a risk premium that reflects only the risk remaining after diversification.

This model provides a general framework for analyzing risk- return relationships for all types of assets. In
evaluating these relationships, CAPM does not use the total risk, which is measured by standard deviation as a risk
measure, but only one part of total risk called systematic risk.

Total risk may be separated into two major components:

1. Diversifiable risk, also called unsystematic risk or company risk

2. Undiversifiable risk, also called systematic risk or market risk

Diversifiable risk or unsystematic risk or company risk is that part of a security’s caused by factors unique to a
particular firm. Unsystematic can be diversified away because it represents essentially random events. Negative
events affecting one firm can be offset by positive events affecting another firm. Sources of diversifiable or
unsystematic risk includes lawsuit, strikes, company management, marketing strategies and research and
development programs, operating and financial leverage, and other events that are unique to the particular firm.
Because these events are random, their effects on a portfolio can be eliminated by diversification.

Undiversifiable risk or systematic risk or market risk is that part of a security’s risk caused by factors affecting the
market as a whole. Systematic risk cannot be eliminated by diversification because it affects all firms
simultaneously. Some companies are more sensitive than others to factors that affect systematic risk. Systematic risk
is therefore the only relevant and is affected by such factors such as wars, inflation, interest rate rates, business
cycles, fiscal and monetary policies, and therefore cannot be eliminated by diversification.
It can be observed that as the number of stocks increases, the diversifying effect of each additional stock or
unsystematic risk diminishes. If stocks included in the portfolio are carefully selected rather than adding them
randomly, the graph would change. In particular, if we choose stocks with correlations with one another and with
low stand- alone risk, the portfolio’s risk would decline faster than if random stocks were added. The reverse would
hold if we added stocks with high correlations and high standard deviation of expected returns.

Since most investors are rational in the sense that they dislike risk, other things held constant. Why would an
investor hold one (or only a few stocks)? Why not hold a market portfolio consisting of all stocks? There are several
answers to the second question.

1. High administrative costs and commission would more than offset the income for individual investors;
2. Index fund can be used by investors for diversification and many individuals can and do get broad
diversification through these funds.
3. Some people believe that they can pick stocks that will “beat the market” so they buy them rather than the
broad market;
4. Some people can, through superior analysis, beat the market; so they find and buy undervalued stocks and
sell overvalued ones. In the process, most stocks become properly valued with their expected returns
consistent with their risks.

CAPITAL ASSET PRICING MODEL ILLUSTRATED

If we know the risk (as measured by beta) of a particular share we can use the capital asset pricing model to
determine that security’s required rate of return. The capital asset pricing model known as CAPM, is a model
developed to help determine a share’s require rate of return for a given level of risk. If an individual chooses to
invest her money, then she must postpone consumption. What rate of return would our investor demand just to
postpone her consumption? We implicitly assume the investor takes on no risk whatsoever, but merely postpones
consumptions. She will want compensation for the wait plus an additional return for any inflationary pressures (an
inflation premium). So, if our investor a 3 percent return to postpone consumption, and another 2 percent to cover
the expected rate of inflation, she would require a 5 percent rate of return. That is, the risk- free rate is 5 percent. For
now let us put her funds into a riskless security that pays a 5 percent rate of return. We tend to think of treasury
securities as a good proxy for a riskless asset because there is no default risk.

Required rate of return = Risk- free rate = 5%

Now, what would it take to get our investor to move from a risk- free asset to a risky asset? That would depend on
the quantity of risk or beta the asset had and what price our investor charges for risk.

Additional
Compensation required = (Price per unit of risk) Beta
For investment in a
Risky asset

We measure the price of risk as the difference between the rate of return on the market as measured by the rate of
return on the S & P 500 Index and the risk- free rate of return

Price
Per unit of = (Return on the market – Risk- free rate)
Risk

We can measure the quantity of risk with a stock’s beta coefficient. Recall that by definition, our riskless asset has a
beta of 0.0, and the market has a beta coefficient equal to 1.0. The market, therefore, has one unit of risk. If we have
multiply the price of risk times the beta, we can determine what our investor is charging per unit of risk.

Additional
Compensation required
for an investment in a = (Price per unit of risk) Beta
Risky asset

The required rate of return on that security is computed as follows:

Required rate of return = Risk- free rate + (Return on the market – Risk- free rate) Beta

Illustrative Case 3-1.

Suppose a particular stock has a risk- free rate of 5% rate of return on the market of 12% and a beta (quantity of
risk) of 1.5. What would be the investor’s require rate of return?

Answer:
The required rate of return is equal to the risk- free rate of return plus price of risk times beta (quantity of risk). The
additional return needed to induce our investor to move from a risk- free investment that has zero units of risk (beta
= 0.0) to an investment that has one and a half units of risk (beta = 1.5) is:
(12% - 5%) 1.5 = 10.5%

Thus, the required rate of return is:

= 5% + (12% - 5%) 1.5

= 15.5 %

Illustrative Case 3-2.

Using the same data as in Case 1 except that the beta is 2.0, what would be the required rate of return?

Answer:

The investor will of course demand a greater rate of return for this large quantity of risk.

The additional compensation required for investment in a risky asset is:

= (12% - 5%) 2
= 14%

The required rate of return is:

= 5% + 14%
= 19%

Comprehensive Case on Determining the Required Rate of Return Using the CAPM Approach

Manaoag Company has a beta coefficient of 1.6. The current rate of return on treasury securities is 9 percent.
Analysis estimate the return on the market portfolio to be 13 percent.

1. What rate of return will an investor require to invest in a risk- free asset?

9%

2. What components make up the risk- free rate of return?

Real rate of interest that is the rate of return it takes to get investors to postpone consumption plus an
inflation premium to protect the investor against rising price levels.

3. What is the price per unit of risk or beta?

(13% - 9%) = 4%

4. What is the quantity of risk or beta?

1.6 units
 5. What rate of return will an investor require to invest in Manaog Company?

Required rate of return = 9% + (13% - 9%) 1.6 = 15.4%

6. What additional return did an investor require to move from a risk- free asset with zero units of risk
to an asset that has 1.6 units of risk?

Additional return needed to induce

An investor to move from the = (13% - 9%) 1.6
Risk- free asset to an asset that = (4%) 1.6
Has 1.6 units of risk = 6.4%

7. Without doing any calculations, what do you think would happen to our investor’s required rate of
return if the quantity of risk went from 1.6 units to 2.4 units? Explain your logic making sure to
answer in words only.

Our investor would require a greater rate of return to compensate for the additional risk. Recall we
assume that all rational investors are risk averse. This means that investors do not like risk and if we want
an investor to take on more risk we have to offer inducements (higher returns).

8. What rate of return would an investor require if the amount of risk increased from 1.6 units to 2.4
units?

Required rate of return = 9% + (13% - 9%) 2.4 = 18.6%

THE BETA COEFFICIENT CONCEPT

When a stock is held by itself, its risk can be the standard deviation of its expected return. However, the standard
deviation is difficult to use when the stock is held in a portfolio as stocks general are. Systematic risk is measured by
a stock’s beta coefficient (b).

Beta is a measure of the sensitivity of a security’s return relative to the returns of a broad- based market portfolio
securities. Beta is defined mathematically as the ratio of the covariance of returns of security (i), and market
portfolio (m), to the variance of returns of the market portfolio. Covariance is an absolute statistical measure of the
extent of two variables, such as securities move together. Beta measure the comovement between a stock and the
market portfolio. The tendency of a stock to move with the market is reflected in its beta coefficient (b), which is a
measure of the stock’s volatility relative to that of an average stock. Beta is a key element of the CAPM. The
succeeding analysis of risk in a portfolio setting is part of the Capital Asset Pricing Model (CAPM).

An average- risk stock is defined as one that tends to move up and down in step with the general market as measured
by some index, such as the Dow Jones Industrials, the S & P 500, or the New York Exchange Index. Such a stock
will, by definition, have a beta (b) of 1.0, which indicates that, in general, if the market moves up by 10 percent, the
stock will also move up by 10 percent, while if the market falls by 10 percent, the stock will move up and down with
the broad market averages, and it will be just as risky as the averages. If b = 0.5, the stock is only half as volatile as
the market- it will rise and fall only half as much –and a portfolio of such stocks will be half as risky as a portfolio
of b = 1.0 stocks. On the other hand, if b = 2.0, the stock is twice as volatile as an average portfolio. The value of
such portfolio could double – or halve – in a short time, and if you held such a portfolio, you could quickly become
a millionaire – or a pauper.

Figure 3-2 graphs the relative volatility of three stocks. The data below the graph assume that in 2012 the “market,”
defined as a portfolio consisting of all stock, had a total return (dividend yield plus capital gains yield) of k m = 10%,
and Stocks A, B, and C (for High, Average, and Low risk) also had returns of 10 percent. In 2013, the market went
up sharply, and the return on the market portfolio was km = 20%. Returns on the three stocks also went up: A soared
to 30 percent. B went up to 20 percent, the same as the market; and C only went up to 15 percent. Now suppose that
the market dropped in 2014, and the market return was km = - 10%. The three stocks’ returns also fell, A plunging to
– 30 percent, B falling to – 10 percent, and C going down only to km = 0%. Thus, the three stocks all moved in the
same direction as the market, but A was by far the most volatile, B was as volatile as the market; and C was less
volatile.

Beta measures a stock’s volatility relative to an average stock, which has b = 1.0, and a stock’s beta can be
calculated by plotting a line like those in Figure 3-2. The slopes of the lines show how each stock moves in
response to a movement in the general market – indeed, the slope coefficient of such a “regression line” is defined as
a beta coefficient. Betas for literally thousands of companies are calculated and published by Merrill Lynch, Value
Line, and numerous other organizations. The beta coefficients of some well- known companies are shown in Figure
3-3. Most stocks have betas in the range of 0.50 to 1.50, and the average for all stocks is 1.0 by definition.

Stock Beta

Apple Computer 1.25

General Electric 1.10
Johnson & Johnson 1.05
Heinz 1.00
Anheuser Busch 1.00
Procter & Gamble 1.00
IBM 0.95
Pacific Gas & Electric 0.70
Energen Corp. 0.65

Source: Value Line, January 10, 1992

If a higher- beta- than- average stock (one whose beta is greater than 1.0) is added to an average- beta (b= 1.0)
portfolio, then the beta, and consequently the riskiness, of the portfolio will increase. Conversely, if a lower- beta-
than- average stock (one whose beta is less than 1.0) is added to an average- risk portfolio, the portfolio’s beta and
risk will decline. Thus, since a stock’s beta measures its contribution to the riskiness of a portfolio, beta is the
theoretically correct measure of the stock’s riskiness.
To summarize, the market risk of a stock is measured by its beta coefficient, which is an index of the stock’s relative
volatility. Some benchmark betas follow:

b = 0.5: Stock is only half as volatile, or risky, as the average stock.

b = 1.0: Stock is of average risk.
b = 2.0: Stock is twice as risky as the average stock.

Since a stock’s beta coefficient determines how the stock affects the riskiness of diversified portfolio, beta is the
most relevant measure of a stock’s risk.

CALCULATING THE BETA COEFFICIENT

To illustrate how betas are calculated, we shall use the following data:

Historical Realized Returns over the Last Five Years

 Year Market Stock X (kj)
1 23.8% 38.6%
2 (7.2) % (24.7) %
3 6.6% 12.3%
4 20.5% 8.2%
5 30.6% 40.1%

Average (k) 14.9% 14.9%

Standard Deviation 15.1 26.5

Procedure:

1. Plot the data points on scatter diagram and draw a line of regression. If the data points had fallen on a
straight line, it would be easy to draw an accurate line. If not, fit the line either by “ocular inspection” as an
approximation or with a calculator.
2. The simple regression line equation means:

Y= a + bX + e

Where: Y = the dependent variable

a = constant
b = slope return on the stock given during a given time period
x = km
e = error term (deviation) for the year, this varies randomly from year to year depending on
company specific factors
3. Once the data have been plotted and the regression line has been drawn on graph paper, we can estimate its
intercept and slope, the a and b values in Y= a + bX. The intercept, a, is simply the point where the line
cuts the vertical axis. The slope coefficient, b, can be estimated by the “risk over run” method. This
involves calculating the amount by which kj increases for a given increase in km. For example, we observe in
Figure 3-4 that kj increases from – 8.9 to + 7.1 percent (the rise) when km increases from 0 to 10.0 percent
(the run). Thus, b, the beta coefficient, can be measured as follows:

b= Beta = Rise = Y = 7.1 – (-8.9) = 16.0 = 1.6

Run X = 10.0 – 0.0 = 10.0

4. The regression line equation enables us to predict a rate of return for Stock J given a value of km. For
example, if km = 15%, we would predict kj = 8.9% + 1.6 (15%) = 15.1 %. However, the actual return would
probably differ from the predicted return. This deviation is the error term, ej, for the year, and it varies
randomly from year to year depending on company- specific factors. Note, though, that the higher the
correlation coefficient, the closer the points lie to the regression line, and the smaller the errors.

In actual practice, monthly rather than annual returns are generally used for kj and km, and five years of data
are often employed; thus, there would be 5 x 12 = 60 data points on the scatter diagram. Also, in practice
one would use the least squares method for finding the regression coefficients a and b; this procedure
minimizes the squared values of the error terms. It is discussed in statistics courses.

PORTFOLIO BETA COEFFICIENT

A portfolio consisting of low- beta securities will itself have a low beta because the beta of any set of securities is a
weighted average of the individual securities’ betas. The beta of the portfolio reflects how volatile the portfolio is in
relation to the market.

For example, if an investor holds a Php 1,000,000 portfolio consisting of Php 333,333 invested in each of 3 stocks
and each of the stocks has a beta of .8, then the portfolio’s beta will be:

bp = (1/3) (.8) + (1/3) (.8) + (1/3) (.8)

= .8

Such a portfolio will be less risky than the market; it should experience relatively narrow price swings and have
relatively small rate- of- return fluctuations. Using the scatter graph, the slope of the regression line would be 0.8,
which is less than that a portfolio of average stocks.

Suppose that one of the existing stocks is sold and replaced by a stock with b1 = 2. This action will increase he
riskiness of the portfolio from bp 1 = .8 to bp 2 = 1.2.

bp 2 = (.3333) (.8) + (.3333) (.8) + (.3333) (2)

= 1.2

Adding a new low- beta stock would reduce the riskiness of the portfolio.

Illustrative Case 3-3. Calculation of Portfolio Beta

You are investing 57.1% or (Php 200,000 out of Php 350,000) of your monthly savings in stocks. You are also
contributing 28.6 percent in bonds and 14.3 percent into a money market treasury bills issued by BSP. The
diversified stock portfolio has a beta of 1. The long- term bond portfolio has a beta 0.18. The treasury bills are risk-
free and thus have a beta of 0.

The beta of this portfolio is therefore:

b = (0.571) (1) + (.286) (.18) + (.143) (0)

= .62

With a portfolio beta of .62, a market return of 11% and a risk- free rate of 5%, you can expect a return of:

5% + .62 (11% - 5%) = 8.7%

If you want a higher expected return, you will have to take more risk. This can be done by increasing your
investment in the stock portfolio.

RELATIONSHIP BETWEEN RISK AND RATE OF RETURN

Financial managers and all managers, for that matter must have a firm grasp upon the trade- off between risk and
return.

First, while the relationship between risk and return is demonstrated here using the capital markets, it equally applies
to many business decisions. A firm’s product mix, marketing campaign combination, and research and development
programs all entail risk and potential rewards. Being able to understand and characterize these decisions within a
risk and return framework can help managers make better decisions. In addition, managers must understand what
return their stockholders require at a various times of firm operations. After all, a firm must receive enough revenue
from its variously risky activities to pay its business costs, debt costs and reward the owners (the shareholders).
Managers must thus include the return to shareholders when they analyze new business opportunities.

The CAPM expresses risk- return relationships using beta as the relevant risk measure. CAPM states that the
required rate of return on a risky asset consists of the risk- free rate plus a premium for systematic risk. The formula
for the capital asset pricing model is:

ri = rf + bi (rm – rf)

where: ri = required (or expected) return on security, i

rf =expected risk- free rate of return
rm= expected return on the market portfolio
bi= beta coefficient of security, i

1. The risk- free rate of return (rr), is the return required on a security having no systematic risk and
is generally measured by the yield on short- term treasury securities such as treasury bills.

a. The risk- free rate consists of two components: a real rate that excludes any inflationary
expectations, and an inflation premium that equals the expected inflationary rate.
b. The risk- free rate changes in the same direction and by the same amount as the inflation
premium changes. Since the risk- free rate is part of a security’s required rate of return, a
change in inflationary expectations will also increase the required return on all securities (r m).

2. The risk premium, bi (rm – rf), is the return required in excess of the risk- free rate and is due to
systematic risk. Part of the risk premium is the market risk premium (r m- rf), which is the
additional return expected for holding a market portfolio of “average” riskiness (b= 1.0). The risk
premium for a specific security will differ from the market risk premium if the individual
security’s beta does not equal to 1.0.

Illustrative Case 3-4. Determination of Portfolio Required Rate of Return Using CAPM Approach.

For example, the betas of Stock 1 and 2 are 2.0 and 0.5, respectively. The risk- free rate is 8 percent and
the expected rate of return on the market is 14 percent. Using the equation for CAPM, the required rates
of return and risk premiums are:

Stock 1 Stock 2
ri= 0.08 + (2.0) (0.14 – 0.08) r2= 0.08 + (0.5) (0.14 – 0.08)
= 0.08 + 0.12 = 0.08 + 0.03
= .20 or 20% = 0.11 or 11%

Stock 1 requires a 20 percent return and has a high risk premium of 12 percent. Stock 2 requires an 11 percent return
and has a low risk premium of 3 percent. The risk premiums are high or low relative to the market risk premium of 6
percent (14 percent – 8 percent), which represents the risk premium on average risk stocks.

SECURITY MARKET LINE (SML)

The CAPM is expressed graphically by the security market line (SML). The security market line represents the
linear relationship between a security’s required rate of return and its risk as measured by beta. The slope of the
SML is the market risk premium (rm – rf) and is constant. For example, an increase in inflationary expectations will
cause the SML to shift upward, but the slope will remain constant. This is because both components of the market
risk premium, namely rm and rf, will increase by the same amount and thus keep the slope constant. However, the
slope of the SML will change if investors become more risk- averse and thus require a higher return for a given level
of risk. Figure 3-5 shows the SML and the risk- return tradeoff of Stock 1 and Stock 2.

CAPM can also be used to calculate a market- based hurdle rate for evaluation purposes. A hurdle rate is the
minimum rate of return required for a project to be accepted. If an asset’s expected rate of return equals or exceeds
the required return (falls on or above the SML), as computed by CAPM, the asset is accepted; otherwise it is
rejected. In equilibrium, the required return of asset or security equals its expected return.

Illustrative Case 3-5. Investment Decision Based on SML

The Illustrative Case 3-4 shows that Stock 1 and Stock 2 have required rates of returns of 20 percent and 11 percent,
respectively. Assume the expected return for Stock 1 is 18 percent and for Stock 2 is 15 percent. Should the
investments be acquired based on the SML?

Figure 3-6 shows that Stock 2’s return is above the SML and should be acquired because its higher expected return
more than compensates for its additional risk. Stock 1 is rejected because it provides less expected return for its risk
than is required.

Comprehensive Case on Security Market Line (SML)

1. The security market line (SML) is a graphical representation of the capital asset pricing model
(CAPM). What relationship does this graph depict?

Depicts the relationship between market risk and required rate of return.

2. What does the slope of the security market that represent?

The slope illustrates the level of risk- aversion in the company.

3. How would the security market line show changes in aversion to risk?

The greater the level of risk aversion, the steeper the slope of the security market line.

4. How would the security market line show changes in the rate of inflation?

The security market line makes a parallel shift when there are changes in the rate of inflation. When
inflation increases the security market line shifts up by the amount of the increase and when inflation
decreases the security market line shifts down by the amount of the decrease.

5. ABC Corporation has a beta of 1.6. The current rate of return on 30- year treasury securities is 9
percent. Analysts estimate the return on the market portfolio to be 13 percent. What is the required
rate of return for ABC Corporation? What is the price per unit of risk?

Required rate of return = 9% + (13% - 9%) 1.6 = 15.4%

Price per unit of risk is (13% - 9%) = 4.0%

 6. If investors became a more risk averse and the rate of return on an average risk equity share (beta =
1) went from 13 to 15 percent, what would be the required rate of return for ABC Corporation?
What happens to the security market line? What is the price per unit of risk?

Required rate of return = 9% + (15% - 9%) 1.6 = 18.6%

SML rotates up (price per unit of risk 6%)

7. If investors became less risk averse and the rate of return on the market portfolio went from 13 to 11
percent, what would be the required rate of return for ABC Corporation? What happens to the
security market line? What is the price per unit of risk?

Required rate of return = 9% + (11% - 9%) 1.6 = 12.2%

SML rotates down (price per unit of risk 2%)

8. If the Consumer Price Index (CPI) went from 3 to 4 percent, what would be the required rate of
return for ABC Corporation? What happens to the security market line? What is the price per unit
of risk?

Required rate of return = 10% + (14% - 10%) 1.6 = 16.4%

SML shifts up parallel (price per unit of risk 4%)

9. If the rate of inflation went from the three percent to two percent, what would be the required rate of
return for ABC Corporation? What happens to the security market line? What is the price per unit
of risk?

Required rate of return = 8% + (12% - 8%) 1.6 = 14.4%

SML shifts down parallel (price per unit of risk 4%)

CONCERNS ABOUT BETA

The CAPM is based on restrictive assumptions about investor behavior and the securities market.

1. Assumptions about investor behavior include:

a. Investors are risk- averse and expect to be rewarded for taking risks;
b. Investors act rationally and prefer a security with the highest return for a given level of risk, or the
lowest risk for a given level of return;
c. Investors make their decisions based on a single time horizon. That is, investors view the asset’s risk
and return characteristics for the same time period, such as a year; and
d. Investors share the same expectations about the risk and return characteristics of securities.

2. Assumptions about the securities market include:

a. All investors can borrow or lend in unlimited amounts at the risk- free rate;
b. Financial markets are frictionless in that there are no taxes or transaction costs;
c. All assets are perfectly divisible and perfectly liquid; and
d. Information is freely available to all investors.
Some of these assumptions do not reflect reality. Although extensive testing of CAPM has produced mixed results,
the findings generally show that expected returns and perceived risk are related and that the market is dominated by
risk- averse investors.

Suppose that an estimate of a firm’s beta was made using monthly data for five years and the Dow Jones Industrial
Average return as the market portfolio. The result is a beta of 1.3. Then, using another estimate was made using
weekly returns for three years and the return from the Standards & Poor 500 Index as the market portfolio’s yield,
resulting in a beta of 0.9. These estimates are quite different and would create a large variation in required return if
they are used in the CAPM. Which is the more accurate estimate? Unfortunately, we may not be able to determine
which is most representative. In general, one may estimate a little different beta using different market portfolio
proxies, different return intervals (like annual returns versus monthly returns) and different time periods.

In addition to these estimation problems, a company can change its risk level and thus its beta, by changing the way
it operates within its business, by expanding into new business and/ or by changing its debt load. Beta’s applicability
and relevance will therefore, depend on the firm’s future plans.

Since characterizing the risk- return relationship is so important, finance researchers have introduced other assets
pricing models. Other models add more risk factors to the predictive relationship other than just market risk. These
factors such as firm size and book-to- market ratio are used along with beta as a measure of market risk.

Source: Financial Management – PRINCIPLES AND APPLICATIONS VOLUME 2 2015 EDITION

Author: Ma. Elenita Balatbat Cabrera BBA, MBA, CPA, CMA