Capital Asset Pricing

Model

Prof Mahesh Kumar

Amity Business School
Introduction
 Capital Asset Pricing Model often referred as CAPM
was developed by William Sharpe, John Lintner and
Jan Mossin.
 This theory hypothesizes how investors do behave
rather than how investors should behave as in case of
MPT.
 This theory deals with two key questions:
1. What is the relationship between risk and return for an
efficient portfolio?
2. What is the relationship between risk and return for an
individual security?
 In essence CAPM predicts relationship between the
risk of an asset and its expected returns.
Importance of CAPM
 This model helps in two ways
1) allows us to measure the relevant risk of an individual
security as well as to assess the relationship between
the risk and returns expected from investing i.e. if we are
analyzing securities, we might be interested in whether
the expected return we forecast is more or less than its
‘fair return’ given its risk.
2) It also helps us to make an educated guess as to the
expected return on assets that have yet not been traded
in the market place.
Assumptions
1. All investors can borrow or lend money at risk free rate of return.
2. All investor have identical distributions for future rates of return
i.e. they have homogenous expectations with respect to the
three inputs of the portfolio model i.e. expected returns, the
variance of returns and the correlation matrix. Therefore, given a
set of security prices and a risk free rate, all investors use the
same information to generate an efficient frontier.
3. All the investors have the same one period time horizon.
4. There are no transaction costs.
5. There are no personal taxes- investors are indifferent between
capital gains and dividend.
6. There is no inflation.
7. There are many investors, and no single investor can affect the
price of the stock through his or her buying and selling
decisions. Investors are price takers and are unaffected by their
own trades.
8. Capital Markets are in equilibrium
CAPM: The Equilibrium Return Risk
Tradeoff
 CAPM is an equilibrium model and
encompasses two important relationships.
a) The capital market line, line specifies the
relationship between expected return and
risk for efficient portfolios.
b) The security market line, line specifies the
equilibrium position between expected
returns and systematic risk for individual
securities.
Capital Market Line
 The straight line drawn from Rf to the efficient frontier with M
tangency point is referred as capital market line.
 CML depicts equilibrium conditions that prevail in the market for
efficient portfolios consisting of the optimal portfolio of risky
assets and risk-free assets.
 The slope of CML is the market price of the risk.
 The equation for CML is
E(Rp)=RF+ E(RM)-RF *σ p

σ M

Where E(RM)-RF is the slope of Capital Market Line

σ M
The Security Market Line
 Capital Market Line applies only to efficient portfolios and cannot be
used to assess the equilibrium expected return for single securities
or inefficient portfolios.
 Typically, the expected returns and standard deviation for individual
securities will be below the CML, reflecting inefficiency of
undiversified holdings.
 Such points would be found throughout the feasible region with no
well defined relationship between their expected return and
standard deviation.
 However, there is a linear relationship between their expected return
and their covariance with the market portfolio. This relationship is
known as Security Market Line (SML) and is depicted as
E(Ri)=Rf+{E(RM)-Rf} *σ iM
σ 2M
The Security Market Line
 Beta is a relative measure of risk-the risk of an individual stock relative
to the market portfolio of all the stocks.
 Securities with different slopes have different sensitivities to the
returns of the market index. If the slope for a particular security is a
45-degree angle, the beta is 1.00. This implies that for every 1-percent
change in the market’s return, on average, this security returns
change 1 percent.
 More volatile stocks have betas larger than 1.00 and less volatile
stocks have beta lesser than 1.00.
 Thus β
i = σ iM
σ 2M
 Inputting the value of β in SML relationship we find:

E(Ri)=Rf+{E(RM)-Rf} *β i
 In other words SML relationship says:

Exp. Ret. on sec. i= Risk free ret.+ Mkt risk prem.+ Beta of security i
The Security Market Line

Return %
•P

•O
β i

 Assets which are fairly priced plot exactly on SML. Under

priced securities such as P plot above the SML, whereas
overpriced securities such as O plot below the SML
 The difference between the actual expected return on a
security and its fair return as per the SML is called the
security’s alpha denoted by α .
Relationship between CML & SML
 As per the SML
E(Ri)=Rf+{E(RM)-Rf} *σ iM

σ M
2

Since σ iM =ρ iM σ iσ M the above relationship can be re written as

E(Ri)=Rf+{E(RM)-Rf} *ρ iM σ i

σ M

If the returns on i and M are perfectly correlated (which is true in case

of efficient portfolios), the above equation becomes
E(Ri)=Rf+{E(RM)-Rf} *σ i
σ M

This is nothing but CML. Hence the CML is the special case of the
SML
Inputs Required for Applying CAPM
 The estimates of the following factors are required for
applying CAPM:
1. Risk Free Rate
2. Market Risk Premium
3. Beta
Risk Free Rate
 The risk free rate is the return on a security (or a
portfolio of securities) that is free from default risk and
is uncorrelated with returns from anything else in the
economy.
 In practice two alternatives are commonly used:
1. The rate on a short term government security like the
364-days Treasury bill.
2. The rate on a long term government bond that has
maturity of 15 to 20 years.
Market Risk Premium
 The risk premium used in CAPM is based on historical
data.
 It is the difference between the average returns on
stocks and the average risk free rate.
 The factors that influence the market risk premium
include:
1. Variances in the underlying economy.
2. Political Risk.
3. Market Structure.
Beta
 The Beta of an investment i is the slope of the following
regression relationship:
Rit= α + β RM2 + eit
Var(Rit)= β 2iσ 2M + Var(eit)
To measure the systematic risk of a stock:
β = σ iM
σ 2
M
Beta-Example
Period Return on Stock A% Return on Market Portfolio
1 10 12
2 15 14
3 18 13
4 14 10
5 16 9
6 16 13
7 18 14
8 4 7
9 -9 1
10 14 12
11 15 -11
12 14 16
13 6 8
14 7 7
15 -8 10
 Beta-Example
Period RA RM RA-RAavg RM-RMavg (RA-RAavg )( RM-RMavg ) (RM-RMavg )2

1 10 12 0 3 0 9
2 15 14 5 5 25 25
3 18 13 8 4 32 16
4 14 10 4 1 4 1
5 16 9 6 0 0 0
6 16 13 6 4 24 16
7 18 14 8 5 40 25
8 4 7 -6 -2 12 4
9 -9 1 -19 -8 152 64
10 14 12 4 3 12 9
11 15 -11 5 -20 -100 400
12 14 16 4 7 28 49
13 6 8 -4 -1 4 1
14 7 7 -3 -2 6 4
15 -8 10 -18 1 -18 1
Beta
 The beta of stock A is equal to
Cov(RA,RM)/σ 2M
Cov(RA,RM)=Σ (RA-RAavg )( RM-RMavg )/n-1=221/15=15.79
σ 2
M=Σ (R M-R Mavg ) 2
/n-1= 624/15= 44.57
So beta of stock A is 624/15=44.57
 What is the CML for stock A?
 α A =RA-BARM=10-0.384*9=6.54%
 The CML for stock A is:
RA=0.654+0.384RM
What is a risk free asset.
 A risk free asset can be defined as one with a certain-to-be-
earned expected return and variance of return as zero.
 Since the variance=0, the nominal risk-free rate in each period
will be equal to its expected value.
 The covariance between the risk free asset and risky asset will
be zero.
 The true risk-free asset is best thought of as Treasury security,
which has no risk of default, with a maturity matching the holding
period of the investor. In this case the amount of money to be
received at the end of the holding period is known with certainty
at the beginning of the period. The Treasury bill typically is taken
to be risk-free asset, and its rate of return is referred as risk free
return.
The Efficient Frontier : The Effect of a
Risk-free Rate
 When a risk-free investment complements the set of
risky securities, the shape of the efficient frontier
changes markedly.

Efficient frontier:
expected return

impossible Rf to M to C
portfolios M = Market portfolio
B
Rf = Risk-free rate
M
E
dominated
Rf portfolios
A

risk (standard deviation of returns)

Risk Free Borrowing and
Lending
 Assume that efficient frontier as shown in the figure
has been derived by the investor. The arc AB
delineates the efficient set of portfolios of risky
assets.
 The return on risk free asset will be plotted on the
vertical axis because the risk is zero.
 Investors can combine this risk less asset with the
efficient set of the portfolios on the efficient frontier.
 The straight line Rf to the efficient frontier at point M,
RF-M, dominates all the straight lines below it and
contains the superior lending portfolio. This is also
known as risk free investing.
Risk Free Borrowing and
Lending
 If extend this analysis to allow investors to
borrow money i.e. the investor is no longer
restricted to his or her wealth when investing
in risky assets implying thereby that we are
short selling the risky assets.
 Borrowing additional investable funds and
investing them together with investor’s wealth
allows investors to seek higher expected
returns while assuming greater risk.
Risk Free Borrowing and
Lending
If it is possible to buy stocks on margin, then the efficient
frontier gets expanded again

Efficient frontier : The ray from Rf

through M and beyond
impossible
expected return

ing
portfolios rro
w
bo

M
ding
len dominated
portfolios
Rf

risk (standard deviation of returns)

The Capital Asset Pricing
Model
What is it?
 An hypothesis by Professor William Sharpe
 Hypothesizes that investors require higher rates of return for greater
levels of relevant risk.
 There are no prices on the model, instead it hypothesizes the
relationship between risk and return for individual securities.
 It is often used, however, the price securities and investments.
 The Capital Asset Pricing
Model
How is it Used?
 Uses include:
 Determining the cost of equity capital.
 The relevant risk in the dividend discount model to estimate a stock’s
intrinsic (inherent economic worth) value. (As illustrated below)

Estimate Investment’s Determine Investment’s Estimate the Compare to the actual

Risk (Beta Coefficient) Required Return Investment’s Intrinsic stock price in the
Value market

COVi,M D1
βi =
σ M2
ki = RF + ( ERM − RF ) β i P0 = Is the stock
kc − g fairly priced?
Market Portfolio and Capital
Market Line
 The assumptions have the following
implications:
1. The “optimal” risky 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 Capital Market Line
9 - 5 FIGURE

ER
CML

The CML is that

 ERM − RF  setThe
of achievable
market
k P = RF +  σ P
ERM M portfolio
Theportfolio
CMLishasthe
 σM  combinations
optimal
standardrisky
thatdeviation
portfolio,
are possible
of
it
contains
portfolio
when investing
all
returns
risky
in as
only
the
securities twoand
RF lies
independent
assets
tangent
(the(T)
market
on variable.
the efficient
portfolio
and frontier.
the risk-free
σρ asset (RF).

σM
The Capital Asset Pricing
Model
The Market Portfolio and the Capital Market
Line (CML)
 The slope of the CML is the incremental expected
return divided by the incremental risk.

ER M - RF
[9-4] Slope of the CML =
σM

 This is called the market price for risk. Or

 The equilibrium price of risk in the capital market.
The Capital Asset Pricing
Model
The Market
 Solving for thePortfolio and
expected return the Capital
on a portfolio Market
in the presence of a RF
Lineasset and given the market price for risk :
(CML)

 ERM - RF 
[9-5] E ( RP ) = RF +  σ P
 σM 
 Where:
 ERM = expected return on the market portfolio M
 σM = the standard deviation of returns on the market portfolio
 σP = the standard deviation of returns on the efficient portfolio being
considered
The Capital Market Line
Using the CML – Expected versus Required
Returns
 In an efficient capital market investors will require
a return on a portfolio that compensates them for
the risk-free return as well as the market price for
risk.
 This means that portfolios should offer returns
along the CML.
 The Capital Asset Pricing
Model
Expected and9 -Required
6 FIGURE
Rates of Return
A is an
B
C a portfolio
overvalued
that
portfolio.
undervalued
offers andExpected
expected
Required portfolio.
return equal
is less
Expected
tothan
the
Return on C
ER CML return
required
the required
is greater
return.
return.
than the required
Expected
A Selling pressure
return on A return.
will cause the price
Demand
to fall andfor
the yield
C Portfolio
to rise until
A will
Required increase driving
expected equalsup
return on A
B the required
price, andreturn.
therefore the
Expected
Return on C expected return will
RF
fall until expected
equals required
(market equilibrium
condition is
achieved.)
σρ
The CAPM and Market Risk
The Security Market Line (SML)
 The SML is the hypothesized relationship between return (the
dependent variable) and systematic risk (the beta coefficient).
 It is a straight line relationship defined by the following
formula:

[9-9] ki = RF + ( ERM − RF ) β i

 Where:
ki = the required return on security ‘i’
ERM – RF = market premium for risk
Βi = the beta coefficient for security ‘i’
The CAPM and Market Risk
The Security Market Line (SML)
9 - 9 FIGURE

ER ki = RF + ( ER M − RF ) βi
M TheSML
The SMLis
ERM uses
usedtheto
beta
predict
coefficient
required as
the measure
returns for
of relevant
individual
RF
risk.
securities

βM = 1 β
The CAPM and Market Risk
The SML and Security Valuation
9 - 10 FIGURE

Similarly,
Required
A is an returns
B is an
ER ki = RF + ( ER M − RF ) βi are forecast using
undervalued
overvalued
this equation.
security
security. because
SML its expected return
You can see
Investor’s willthat
sell
is greater than the
thelock
to required
in gains,return
required return.
Expected A on any
but the security
selling is
Return A
a functionwill
Investors
pressure will
of its
Required
Return A B
systematic
‘flock’
cause to
theA market
and
risk bid
(β)
RF andthe
up
price market
toprice
fall,
factors the
causing (RF and
expected
market
return
expected to fallreturn
till itto
premium
equals
rise untilthe for
it equals
βA βB β risk)
required
the requiredreturn.
return.
The CAPM in Summary
The SML and CML
 The CAPM is well entrenched and widely used by
investors, managers and financial institutions.
 It is a single factor model because it based on the
hypothesis that required rate of return can be
predicted using one factor – systematic risk
 The SML is used to price individual investments
and uses the beta coefficient as the measure of
risk.
 The CML is used with diversified portfolios and
uses the standard deviation as the measure of risk.