Preliminaries

Asset pricing

Intuition

Conclusion

Lecture 5: The Capital Asset Pricing Model

SAPM [Econ F412/FIN F313 ]

Ramana Sonti
BITS Pilani, Hyderabad Campus
Term II, 2014-15

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Lecture 5: The Capital Asset Pricing Model

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

Agenda
1 Preliminaries

Introduction
2 Asset pricing

The market portfolio

The CAPM equation
Example
The security market line
3 Intuition

In words
In pictures
4 Conclusion

Beta as a regression coefficient

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Lecture 5: The Capital Asset Pricing Model

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

Introduction

Asset pricing models and the CAPM

Needed: A model to relate risk to return this is the ambitious goal

of asset pricing
useful to calculate the cost of capital
useful as a key input in portfolio allocation
useful in measuring portfolio performance

The CAPM is
the earliest APM ... circa 1962
a theoretical APM ... derived wholly from first principles, and not

motivated by data
an APM based on the concept of equilibrium ... meaning an economic

state where no one wants to do anything differently

a very popular APM ... especially in the practitioner world
does not seem to be confirmed by the data ... some claim it is not even

testable

Depends on a bunch of strong assumptions (see next page)

Stringent assumptions are the price to pay for the models elegance
Many of the assumptions can be relaxed
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Lecture 5: The Capital Asset Pricing Model

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

Introduction

Assumptions underlying the CAPM

The heroic assortment of assumptions (which even finance

professors do not believe!)

Investors are in perfect competition with each other. No one investor

has the ability to influence prices with her/his trade

All investors have the same one-period horizon. Could be a year, a

month or a week
All investors are Markowitz efficient investors, who care only about the

mean and variance of their portfolios

All investors have homogeneous expectations i.e. have identical

probability distributions regarding asset returns

Markets are frictionless, meaning
Investors can borrow or lend any amount at the risk-free rate
Investments are infinitely divisible one can buy or sell any fraction of any
asset.
No taxes or transactions costs
There is no inflation or change in interest rates, or inflation is fully
anticipated.
Capital markets are in equilibrium all securities are properly priced

taking into account their risk

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Lecture 5: The Capital Asset Pricing Model

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

The market portfolio

The market portfolio: Example

All investors have identical expectations they all graph the same

efficient frontier, and end up with the same MVE portfolio

Consider a highly simplified world with only 2 investors and 2 assets
Assets: Infosys and Reliance stocks; Let MVE portfolio be 70% I and
30% R
Investors: Mr. Squeamish and Ms. Bungee Jumper with Rs. 1 M

apiece
S has an optimal complete portfolio of 40% T-bills and 60% MVE.

Then, BJ must have -40% T-bills and 140% MVE

Investor
I
R
T-bills
Total
S
420,000
180,000
400,000
1,000,000
BJ
980,000
420,000 -400,000 1,000,000
Total
1,400,000 600,000
0
2,000,000
Note 1: Net supply of risk-free assets is zero
Note 2: Fraction of I in market=1.4/2.0=70%; Fraction of R=30%

Lesson: Under CAPM assumptions, the market portfolio is MVE

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Lecture 5: The Capital Asset Pricing Model

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

The market portfolio

The market portfolio: Details

Definition: The market portfolio is a portfolio of all risky assets in the

economy, with each asset in proportion to its market value

Weight of asset i in mkt. portfolio =

Market value of asset i

Total market value of all risky assets

All risky assets includes stocks, bonds, currencies, derivatives, real estate, commodities,
human capital etc.

What would happen if there is new information suggesting that

Infosys stock is underpriced?

You would revise your expected return forecast upward for I . (With no change in the risk of
I ) your revised MVE portfolio should contain a bit more than 70% of I

However, at the same time, everybody else is doing the identical thing, arriving at the same
revised MVE portfolio

Supply of I shares is fixed; the only thing that can happen is that the stock price of I
increases

The price of I adjusts to a new level such that the new market portfolio is again MVE
This is the logic of equilibrium

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Lecture 5: The Capital Asset Pricing Model

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

The CAPM equation

The pricing model: Part 1

Since we now know that the market portfolio is MVE, we can draw a

Capital Market Line (CML)

Portfolio expected return

Market

CML

Portfolio standard deviation

All efficient portfolios must lie along the CML, i.e, they have to satisfy

E(re ) = rf +
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E(rm ) rf
m

Lecture 5: The Capital Asset Pricing Model

!
e
Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

The CAPM equation

The pricing model: Part 2

What about inefficient assets, e.g, individual assets?

The CAPM:
where

h
i
E(ri ) = rf + i E(rm ) rf ,
i =

Cov(ri ,rm )
m2

In plain English, the expected return on any asset over and above

the risk free rate must be determined by the sensitivity (beta) of that
asset w.r.t. the market portfolio, and the risk premium on the market
portfolio

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Lecture 5: The Capital Asset Pricing Model

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

The CAPM equation

CAPM: Proof
Heres an intuitive proof:
Recall the useful property of the MVE portfolio that says marginal

reward-to-risk ratios of all risky assets must be the same at the MVE
In the CAPM context, substituting the market portfolio instead of the

MVE, we can write:

E(ri ) rf
E(rj ) rf
=
Cov(ri , rm ) Cov(rj , rm )
Since this is true for any two risky assets i and j, it must also be true

for the market portfolio itself, which is a valid risky asset

Substituting j = m, we have:

E(ri ) rf
E(rm ) rf
E(rm ) rf
=
=
Cov(ri , rm ) Cov(rm , rm )
Var(rm )
which reduces to

h
i
E(rm ) rf
h
i
E(ri ) = rf + i E(rm ) rf

E(ri ) rf =

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Cov(ri ,rm )
Var(rm )

Lecture 5: The Capital Asset Pricing Model

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

Example

CAPM: Example
Lets try and write out the CAPM for our 3-asset example from the

previous lecture
Recall that

0.10

= 0.20

0.15

0.0049

= 0.0007

0.0007
0.01
0.0108

0
0.0108
0.0144

If you remember, the MVE (or tangency) portfolio of these three

assets is wX = 0.2274, wY = 1.7793, wZ = 1.0067
Although the math is right, this cannot be a valid market portfolio

(why?)

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Lecture 5: The Capital Asset Pricing Model

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

Example

CAPM: Example ... contd.

Lets tweak the numbers to

0.10
0.0049

= 0.20 and = 0.0032

0.15
0.0013

0.0032
0.01
0.0054

0.0013
0.0054
0.0144

The MVE (or tangency) portfolio of these three assets is

wX = 0.0546, wY = 0.8424, wZ = 0.1030. It is easy to calculate
E(rm ) = 0.1894 and m = 0.0922
Calculate the betas of the individual assets:
Asset

rf
Market
X
Y
Z

Cov(ri , rm )
0
0.0085
0.0031
0.0092
0.0061

Var(rm )
0.0085
0.0085
0.0085
0.0085
0.0085

0.0
1.0
0.36
1.08
0.72

E(ri )
0.05
0.1894
0.10
0.20
0.15

Ratio
16.3895
16.3895
16.3895
16.3895

Obviously, beta and expected return go hand in hand

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Lecture 5: The Capital Asset Pricing Model

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

The security market line

The security market line

The Security Market Line (SML) is a graph of the CAPM
0.25
SML

0.2

Portfolio expected return

Market

0.15

0.1

0.05

0
0

0.5

1
Portfolio beta

1.5

In equilibrium, all assets should lie on the SML

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Lecture 5: The Capital Asset Pricing Model

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

The security market line

CML versus SML

0.25

0.25
SML

Market
H0.055, 0.842,0.103L

0.2
Y

0.15

Market

Z
CML

0.1

0.15

0.1

0.05

0.05

0
0

Portfolio expected return

Portfolio expected return

0.2

0.02

0.04
0.06
0.08
0.1
Portfolio standard deviation

0.12

0
0

0.5

1
Portfolio beta

1.5

All assets lie on the SML. Only the risk-free asset and the market lie on the CML
Investments with same expected return could have different standard deviations, but
they must all have the same beta, and vice versa

Entire lines of points in the CML diagram plot at the same point in the SML
diagram
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Lecture 5: The Capital Asset Pricing Model

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

In words

What the CAPM is saying (in English)

Covariance (with the market portfolio), not variance, is the

appropriate measure of risk

The marginal contribution of an asset to a portfolios risk is entirely due

to its covariance with the market

High beta assets have high expected returns

High beta assets produce high returns when the market return is high,

i.e., when the marginal value of an extra $1 is low. Low beta assets
have the opposite property
When you really need the money (in bad states of the world), high beta
assets fare poorly. So, to induce investors to hold these assets, they
have to offer high expected returns

Beta alone determines expected returns

Once beta is taken into account, nothing else matters for expected

returns
This is the implication that has been incompatible with historical data

Diversifiable risk is not priced, i.e., if an investor is dumb enough not

to diversify, he will not be compensated

Remember the formula: Return on Idiocy (ROI) =0
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Lecture 5: The Capital Asset Pricing Model

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

In pictures

Graphical intuition
Say we look at all combinations of Asset Z and the market portfolio
In equilibrium, this combinations curve lies entirely inside the risky

asset efficient frontier, and is tangent to the CML

There is nothing to be gained (in terms of Sharpe ratio) by adding (subtracting) Z to (from)
the market

The same condition should be true for every risky asset

This is a state of equilibrium, where the marginal reward-to-risk ratio is equal across all
assets

Now, suppose you have private information that E(rZ ) = 0.20, not
0.15 as everyone else in the market expects it to be (every other

number being unchanged)

The combinations curve lies partly outside the risky asset efficient frontier, and is no
longer tangent to the CML

There is some Sharpe ratio to be gained by adding some Z to the market, represented by a
new (your own private) CAL

This is a state of disequilibrium, where the marginal reward-to-risk ratio is not equal across
all assets

Of course, this information will eventually find its way to the market, and everyone will
revise their portfolios etc., and the equilibrium condition will be restored

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Lecture 5: The Capital Asset Pricing Model

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

In pictures

Graph: Equilibrium
0.25

0.2

Portfolio expected return

Mkt

0.15
Z
CML

0.1

0.05

0
0

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0.02

0.04

0.06
0.08
Portfolio standard deviation

Lecture 5: The Capital Asset Pricing Model

0.1

0.12

0.14

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

In pictures

Graph: Disequilibrium
0.25

0.2
Z

Portfolio expected return

New CAL

Mkt

0.15

CML

0.1

0.05

0
0

17/27

0.02

0.04

0.06
0.08
Portfolio standard deviation

Lecture 5: The Capital Asset Pricing Model

0.1

0.12

0.14

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

In pictures

Disequilibrium and the SML

Another way to see this is to plot the SML
Asset Z is off the SML, which cannot happen in the CAPM equilibrium
0.25
SML

Portfolio expected return

0.2

Market

0.15

0.1

0.05

0
0

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0.5

1
Portfolio beta

Lecture 5: The Capital Asset Pricing Model

1.5

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

In pictures

Supply, Demand and CAPM equilibrium

Lets examine in detail an example.
A simple set-up: The risk free rate is 5%. In addition, there are two

risky assets, Bottom Up (BU) and Top Down (TD). Details given below:
Asset
No. of shares

E(P1 )
D1

BU
5M
40
6.40
40%
0.20

TD
4M
38
3.80
20%
-

Investors are Sigma (S), an actively managed fund with a corpus of

220M, and an Index fund (I ) with a corpus of 130M

What should the current market prices of the stocks BU and TD be

in equilibrium?

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Lecture 5: The Capital Asset Pricing Model

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

In pictures

Determining the price of BU

Lets start with a pair of prices (pBU , pTD ) = (38, 39)
These prices imply expected returns
[(E(rBU ), E(rTD )] = (0.2211, 0.0718)
Using these and the variances and covariances, we have
wBU,MVE = 0.8964; wTD,MVE = 0.1036
385
The market portfolio is wBU ,m = 385+394
= 0.5491; wTD,m = 0.4509
Sigmas demand for BU is then 0.8964 220/38 = 5.19 M shares,
while the Index funds demand for BU is 0.5491 130/38 = 1.88 M
shares. Total demand is therefore=5.19 + 1.88 = 7.07 M shares

Substituting different values of pBU (keeping pTD = 39), we can

generate a demand curve for BU shares

Finally, intersecting the demand curve and the supply curve, we
obtain an equilibrium price for BU shares, which is pBU = 40.85

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Lecture 5: The Capital Asset Pricing Model

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

In pictures

BU price determination: Graph

10

BU Quantity HM sharesL

PHBUL=40.85
4

0
35

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36

37

38
BU Price

Lecture 5: The Capital Asset Pricing Model

39

40

41

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

In pictures

TD price determination: Graph

10

TD Quantity HM sharesL

PHTDL=38.14

0
35

36

37

38

39

40

TD Price

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Lecture 5: The Capital Asset Pricing Model

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

In pictures

Full Equilibrium
For these prices to be a full equilibrium, (not just a partial one) we

need the prices of BU and TD to be consistent with each other

Assuming pTD = 39, the equilibrium price of BU is 40.85
Now, using price pBU = 40.85, find the equilibrium price of TD. Is it
39? No, it is 38.90. In other words, (40.85, 39) is an inconsistent pair of

prices
Keep iterating the trial-and-error process until we end up with a

consistent pair of prices

It turns out that the full equilibrium pair of prices is (39.2228, 38.4714)

(Verify this!)

At this equilibrium pair of prices

Demand functions for S and I are derived, respectively, from the MVE
and market portfolios
Market for BU shares clears, given price of TD
Market for TD shares clears, given the price of BU

At the full equilibrium prices, what is the relationship between the

MVE and the market portfolios?

See graphs on following pages
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Lecture 5: The Capital Asset Pricing Model

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

In pictures

Full equilibrium
39

39

38

38

37

TD price

40

TD Price

P HTDL=38.47

40

4
6
TD Quantity HM sharesL

37
36

36

P HBUL=39.22,P HTDL=38.47

35
35

35
10

36

37

38

39

40

38

39

40

BU price

BU Price

BU Quantity HM sharesL

35
10

36

37

8
6
P HBUL=39.22
*

4
2
0

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Lecture 5: The Capital Asset Pricing Model

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

In pictures

Convergence to full equilibrium

0.565

0.56

BU weight

0.555

0.55

0.545

0.54

10

15

20
Iteration

25

30

35

As the market converges to full equilibrium, the MVE (red) and market (blue)
portfolios converge to the same point

This process of convergence is called tatonnement (French for, roughly trial and
error)

Imagine this onerous process with thousands of stock and millions of investors!
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Lecture 5: The Capital Asset Pricing Model

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

Beta as a regression coefficient

Why beta is called beta

Lets start with the
regression equation:
 following

ri rf = i + i rm rf + i
This is not the CAPM. It is simply a regression of asset is excess returns on the markets
excess returns

In English: Excess returns of asset i depend on the markets excess returns. There is an
idiosyncratic shock beyond the effect of the market

Taking expectationsh on both sides,

we have:
i
E (ri ) rf = i + i E (rm ) rf + E(i )
From standard regression assumptions, we can write E(i ) = 0,i.e, the idiosyncratic part of
return is unpredictable

If the CAPM is true, it must be true that i = 0,i.e., i must be interpreted as the systematic
out-performance (or under-performance) of asset is return relative to the CAPM

Taking the variance of both sides, we have:

i2 = i2 m2 + 2i + 2i Cov (i , rm )
Another standard regression assumption is that Cov (i , rm ) = 0, i.e., i is idiosyncratic,
precisely because it is uncorrelated with the markets return

Therefore, i2 = i2 m2 + 2i ,i.e., total risk is the sum of systematic risk and idiosyncratic risk;
the latter is not priced according to the CAPM

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Lecture 5: The Capital Asset Pricing Model

Ramana Sonti

Preliminaries

Asset pricing

Intuition

Conclusion

Beta as a regression coefficient

Final thoughts
Remember that CAPM betas are linear, i.e.,
p = w1 1 + w2 2 + + wn n
There have been several extensions of the CAPM, relaxing the basic

assumptions. BKMM provides some details I will not cover

extensions here
The CAPM does not seem to fit historical data well; however, we

study it so that we develop intuition before proceeding to more

complicated models
Remember that regardless of the validity of the CAPM,

mean-variance optimization remains a useful model for portfolio

allocation

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Lecture 5: The Capital Asset Pricing Model

Ramana Sonti