Chapter 6 Risk and Return: The CAPM and Beyond

Chapter Overview
The Opening Focus demonstrates the use of the CAPM by the authority (STB) that governs the
rairoad industry! "sing the CAPM to cacuate the cost of capita #i bring the rairoad industry
in ine #ith the rest of the corporate #ord! But the rairoads are concerned that this change #i
o#er the estimates of the cost of capita #hich #oud in turn o#er prices!
This chapter$ #hich continues the ris% and return concepts introduced in the previous chapter$
e&tends the Capita Asset Pricing Mode and oo%s at aternatives to the CAPM and mar%et
e'uiibrium!
This chapter discusses(
1. Efficient Risky Portfolios
2. Risk-free Borrowing and Lending
3. Equilibrium and te !arket Portfolio
". #e $a%ital &sset Pricing !odel
'. Em%irical E(idence on te $&P!
). &lternati(es to te $&P!
*. $urrent +tate of &sset Pricing #eory
Lecture Guide
Introduction
This chapter ta%es up #here Chapter ) eft off! Chapter ) introduces the idea about beta being the
reevant measure of ris%! *f investors ony are concerned about systematic ris%$ and beta
measures this ris%$ then there shoud be a positive correation bet#een beta and returns! This is
the core of the Capita Asset Pricing Mode!
+!, -fficient .is%y Portfoios
*! Efficient Frontier: /iscuss ho# an efficient frontier is created! *t is easier to
envision #ith 0ust t#o assets! *f you combine the t#o assets in every #ay
possibe$ compute the standard deviation and return of each possibe combination
and pot those points$ you #i have a picture simiar to that in Figure +1,! 2ou
get appro&imatey this shape for combinations of any t#o ris%y assets! 3hie it
is difficut to manuay ma%e the cacuations for portfoios #ith more than t#o
assets$ as you add assets$ you continue to get a picture #ith roughy the same
shape!
A! Student Appication( As% students if everyone #oud #ant to purchase
the minimum variance portfoio! Many #i say yes! This is a good
pace to bring bac% in Chapter )4s concept of ris% aversion! Peope have
different degrees of ris% aversion! 3hie the most ris%1averse individuas
might #ant to purchase the minimum variance portfoio$ more aggressive
investors might be #iing to ta%e on more ris% and invest in a ris%ier
portfoio! 5ote aso that the more assets that are added to a portfoio$ the
more ris% reduction is achieved$ #ithout a corresponding decrease in
return!
+!6 .is%1free Borro#ing and 7ending
*! .is%1free 3ord( -&pain ho# the possibiity of borro#ing and ending
ma%es everyone happier! The most ris%1averse investors$ those #ho #ant
to invest in more of the ris%1free asset$ choosing safety over a higher
return$ have higher returns! But so do the east ris%1averse investors$ #ho
#ant to invest more than ,889 of their #eath in the ris%y asset!
A! Student Appication( As% students ho# you can invest more than
,889 of your #eath in ris%y assets! 2ou coud iustrate this
#ith information about buying on margin! -&pain that some
investors put do#n ony a part of the re'uired e'uity investment
and borro# money from their bro%er to invest more in stoc%s
than their current #eath! As Figure +1) sho#s this can be a very
ris%y strategy$ particuary if the stoc% mar%et turns do#n! As%
students #hat %ind of investors are i%ey to end money
(retirees) and #hich are more i%ey to borro# money to buy
stoc% (generay younger$ more aggressive investors)!
+!: -'uiibrium and the Mar%et Portfoio
*! -'uiibrium( Point out that capita mar%et ine is the tangency ine from the
previous section! *nvestors #i ony #ish to hod portfoios aong this ine! The
ine provides a #ay to mathematicay 'uantify the inear reationship bet#een
portfoio ris% and return!
+!; The Capita Asset Pricing Mode
,. CAPM: The ne&t step is to sho# that #hie the capita mar%et ine 'uantifies ris%
and return it does not 'uantify reevant ris% and return! This can be done by
changing the &1a&is to beta instead of standard deviation! 5ote that an important
assum%tion of te model is tat in(estors old di(ersified %ortfolios$ #hich
may not necessariy be the case for a investors! <o#ever$ if an investor does
not hod a diversified portfoio$ he or she will not be com%ensated for all te
risk borne by te %ortfolio.
A! -&ampe( As an iustration$ mutua funds typicay hod many stoc%s$ more
than enough to be considered diversified! *f the mar%et re#arded ta%ing on
nonsystematic ris%$ then mutua funds #oud se at a premium to the vaue
of their underying shares! *nstead$ most mutua funds fai to ma%e e&cess
returns$ particuary after ta%ing transactions costs and fund fees into account!
**! Note the assumptions of the CAPM(

There are no transactions costs or ta&es!

*nvestors have identica e&pectations and assessments of an asset4s ris%!

*nvestors choose some combination of the ris%y portfoio and the ris%1free
asset!
A! Student Appication( As% students #hich assumptions are true in the rea
#ord! 3hat happens if the assumptions are vioated= The mode assumes
investors are right on average > they don4t have to be right a of the time!
+!) -mpirica -vidence on the CAPM
*! -vidence( The CAPM is an e&tensivey1studied mode$ and for the most part has
been found to #or% #e enough! Point out to students the five testabe
assumptions of CAPM(

Return sould increase wit risk.

#ere sould be a linear relationsi% between risk and return.

-onsystematic risk sould not im%act returns.

#e slo%e of te security market line sould be te market risk

%remium. E /Rm0 1 Rf.

#e interce%t of te +!L sould be te risk free rate.

A! The first three have been empiricay verified$ but te slo%e is not as stee%
as $&P! %redicts. and te interce%t is a little iger tan $&P!
%redicts! This doesn4t mean CAPM doesn4t #or%? it 0ust isn4t perfect and is
sti #idey used in practice in spite of its shortcomings!
i! *t is true that for some stoc%s$ average return has not depended on beta at
certain times! For e&ampe$ there #as a period of time #hen Appe
Computer #as financiay distressed! *ts beta #as computed at that time
as 8!6$ seemingy very o# ris%! At the same time *BM had a beta of ,!,!
7oo%ing at betas aone$ you #oud concude that Appe #as a much safer
investment than *BM! This certainy #as not true! Appe #as very ris%y
because of its financia distress$ but it #as temporariy disconnected from
the mar%et! *nstead of moving up #hen the mar%et #ent up or do#n
#hen the mar%et #ent do#n$ it #as moving up and do#n because of
ne#s about the company4s fortunes! This means that you must oo%
carefuy at beta! /epending on #hat historica period #as used to
compute beta$ the resuting beta may or may not be representative of the
future ris% of the company! *t #oud have been more reasonabe in
Appe4s case to use a historica period #hen Appe #as heathy or to use
an industry average$ if you beieved Appe #oud eventuay recover
from its financia difficuties!
+!+ Aternatives to the CAPM and the Current State of Asset Pricing Theory
*! Student Application: As% students #hat other factors might be important! To
#hich companies might they be important= For e&ampe$ if oi prices are a
factor$ #hich companies #oud be more infuenced by changes in oi prices!
5ote that the 2ama-2renc model as been critici3ed as %ossibly being te
result of data mining4 if you oo% at enough possibe reationships$ you4 i%ey
find some that have #or%ed in the past! An e&ampe of this is the fact that the
number of bars in a city is positivey correated #ith the number of churches in
the city! 2ou coud deveop a theory about #hy this is happening > are the
drin%ers repenting and going to church more= Or are the churches driving peope
to bars= 2ou coud deveop a theory about #hether bars cause churches or
churches cause bars$ but you #oud be incorrect! Bars and churches appear to
have a reationship$ but it is e&pained by the fact that city si@e is the controing
factor > a bigger city has both more bars and more churches!
Enrichment Exercise
,! As% students to pic% a company and do#noad stoc% prices and inde& data (2ahooA Finance is
a good source for this!) They shoud then compute tota ris% by converting their price series
into a return series by cacuating returnt 5 /Pt - Pt-106Pt-1. Cacuate the mean$ standard
deviation and coefficient of variation of returns for the stoc% using the data you have
coected!
$alculate beta by regressing te stock7s returns on te returns to te inde8 cosen!
7oo% up your companyBs rea beta > there are many onine sources for this! Compare
pubished betas to the cacuated beta! 3hy are they different= 3hat difference does time
period ma%e=
6! Co bac% to the enrichment e&ercise in the previous chapter! <ave the groups cacuate the
return on each of the stoc%s in their portfoio using CAPM! "se betas from at east t#o
different #eb sites! Cacuate a portfoio beta aso! /oes it change your ans#er= 3as the
ris%iest portfoio the one #ith the greatest return=
Answers to Concept Review Questions
,! The minimum variance portfoio is efficient! Portfoios ying aong the continuation of the
ine do#n and to the right are not efficient? they are dominated by portfoios that offer a
higher return for the same amount of ris%! There are many efficient portfoios that are not
minimum variance! They provide the east variance for a given eve of ris%$ ho#ever!
6! An efficient portfoio provides the most return for the east ris% or the east ris% possibe for
the most return! .is%1averse investors #i a#ays choose the portfoio #ith the most return
for a given amount of ris% or the east ris% for a given return! 5ote that there are not
necessariy efficient portfoios at every eve of ris% and return!
:! -&panding the assets in the feasibe set moves the efficient frontier to the eft? in other #ords$
it provides ess ris% for the same return!
;! The four stoc%s have differing correations! An e'uay #eighted portfoio does not ta%e
advantage of the correations by$ for e&ampe$ incuding more of stoc%s that are negativey (or
at east ess positivey) correated #ith the other securities!
)! The standard deviation of a portfoio of ris%y assets and the ris%1free asset is the #eight hed
in ris%y assets mutipied by the standard deviation of the ris%y asset! This #i vary as the
#eight of ris%y assets changes$ a inear reationship! *f t#o ris%y assets have @ero correation$
the third term in the e'uation for portfoio variance disappears$ but the e'uation for portfoio
variance becomes the #eights s'uared times the variances of the assets! This is no onger a
inear reationship!
+! By borro#ing money$ an investor can invest ess of their o#n #eath in ris%y securities! The
investor #i receive a higher return for a o#er initia investment$ magnifying their #eath if
the investment earns money! The e&pected return of the portfoio increases because more
money is invested in ris%y assets! .is% is increased because the investor has the potentia of
not ony osing his persona investment but aso becoming responsibe for repaying the
borro#ed money if the investment does not increase enough for him to do so from gains from
the investment!
D! 3hen ris%1free ending and borro#ing is possibe$ an investor #i invest in the optima ris%y
portfoio and the ris%1free asset!
E! There is ony one point at #hich the interest rate ine is tangent to the efficient frontier$ the
optima ris%y portfoio! Any ine o#er than the ine that connects to the tangency portfoio is
inferior (o#er return for the same eve of ris%) to a portfoio on the tangency ine! The
remaining portfoios are dominated by tangency portfoio and ris%1free asset combinations!
F! The mar%et price of ris% determines return! *f ris% is pricier$ then there #i be a higher
e&pected return! *nvestors #ant to ma&imi@e the mar%et price of ris% because this ma&imi@es
return!
,8! 2ou coud construct a portfoio #ith a standard deviation greater than the mar%et standard
deviation by borro#ing money and investing more than ,889 of your assets in ris%y
securities!
,,! A assets above the security mar%et ine return more than CAPM says they shoud return!
This is a desirabe asset! *nvestors #i buy the asset$ driving the price up and the yied do#n
unti it ies on the security mar%et ine!
,6! Beta is a measure of the absoute eve of systematic ris%! .1s'uared measures ho# much
systematic ris% a security has$ reative to its tota ris%!
,:! CAPM says return is reated to ris% as measured by beta$ so higher beta stoc%s have higher
e&pected returns!
,;! An SM7 that is Gtoo fatH means the sope$ or mar%et ris% premium$ #as not as high as
e&pected!
,)! *f investors4 ris% preferences change$ this #i change the mar%et ris% premium$ - (.m) > .f!
*f the sope of the SM7 changes$ returns #i change! .eturns #i become higher #ith
steeper sopes and o#er #ith fatter sopes! *f investors become ess ris% averse during
booms$ they #i not re'uire as high returns and security prices #i be bid up! The reverse
#i happen if investors re'uire higher returns during recessions$ bidding prices do#n! A
non1constant ris% premium means it #i be harder to determine the underying causes of the
ris%1return reationship!
,+! <igh boo%1to1mar%et ratio companies coud earn higher returns because they are more ris%y
than o# boo% to mar%et ratio companies! *f they are more ris%y$ they shoud earn higher
returns! On the other hand$ technoogy companies fre'uenty have high mar%et vaues and
o# boo% vaues$ yet they are very ris%y companies! *nvestors coud be too pessimistic about
a company$ driving do#n mar%et vaues and driving up boo% to mar%et ratios! Over time$ as
they reai@ed they #ere #rong about the companies$ they push prices bac% up! The reverse
happens for o# boo% to mar%et firms!
,D! The Fama1French mode is an appication of asset pricing theory in the sense that F1F says
there may be more factors affecting return other than mar%et ris%! Fama and French
specificay state that there are three factors!
The main esson of asset pricing theory is that investors demand more return for ta%ing on more
ris%! Systematic ris% is the main driver of returns