The Mean-Variance Capital Asset Pricing Model

Positive theories make strong (often unrealistic) assumptions, but

positive theories are judged on the basis of their predictions not their assumptions. assumptions Assume: All investors are MV decision makers All investors have the same time horizon All investors share homogeneous beliefs A riskless asset exists and all investors can borrow or lend at the same riskless interest rate Assets are infinitely divisible There are no transactions costs e e a e o a sac o s cos s There are no taxes

The Capital Asset Pricing Model

Two very important relationships characterize the MV CAPM:

Capital Market Line

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

The Capital Market Line shows the risk - return tradeoff for portfolios Efficient (and only efficient) portfolios plot on the capital market line

Security Market Line

The security market line takes one of two forms

E ( rj ) = rf + E ( rm ) rf j
E ( rm ) rf E ( rj ) = rf + 2 m

where

cov(rj , rm )
2 m

cov(rj , rm )

The security market line provides the risk-return tradeoff for individual assets. In equilibrium everything plots on the security market line equ b u eve y g pos o e secu y e e individual assets and portfolios (both efficient and inefficient).
3

CAPM: Reward Risk Tradeoffs Portfolios and Securities

The SML in mean covariance space

The SML in mean covariance space

 2 = xi x j ij p
i j

= xi x j ij
i j

= xi cov(ri , rp )
i

2 = p

x1 x111 + x1 x2 12 + x1 x313 + + x2 x1 21 + x2 x2 22 + x2 x3 23 + + x3 x1 31 + x3 x2 32 + x3 x3 33 + + + xn x1 n1 + xn x2 n 2 + xn x3 n 3 +

+ x1 xn 1n = x1 x j 1 j
j

+ x2 xn 2 n = x2 x j 2 j
j

+ x3 xn 3n = x3 x j 3 j + + =
j j

+ xn xn nn = xn x j nj 2 = xi x j ij p
i j

where

x =x
j ij j j

cov(ri , rj ) = cov(ri , x j rj ) = cov(ri , rp )

j
7

A Formal Derivation of the SML

Assume there is a representative investor with risk tolerance Tm . This investor will neither borrow nor lend in equilibrium. Form the Lagrangian expression and take derivatives

max L = Tm

( x + rx ) (1/ 2)
i i i r i

xi x j ij + (1 i xi xr )
n equations

(1) (2)

L / xi = Tm i j x j ij = 0

L / xr = Tm r = 0
L / = x j + xr = 1
j

1 equation

(3)

1 equation

(4)
8

From equation (3)

/ Tm = r

(5)

Rearrange equation (2) and use equation (5) to find a "disguised" form of the SML

1 i = r + Tm

1 j x j ij = r + T cov(ri , rm ) m

(6)

Multiply each side of equation (6) by xi and sum over all the risky assets

1 i xi i = r i xi + T m

x
i i

x j ij

(7)
9

 Recognize that: (i) the representative investor neither borrows nor lends, which means that the xi are the market portfolio weights and (ii) (iii)

x
i

=1,

m = i xi i , and
2 m = i xi j x j ij

Then we can rearrange equation (7) to find that

m r 1 = 2 m Tm

(8)

10

When we substitute equation (8) back into equation (6) we have the SML

m r i = r + cov(ri , rm ) ( 2 m

(9)

The result follows directly from the fact that the representative investor is a mean-variance decision maker

11

Disequilibrium Analysis: Alpha measures abnomal return

If we are not in equilibrium securities do not plot on the SML This stock is underpriced, investors demand it, driving its price up and expected rate of return down

12

The Market Model

Another Way to Think about Portfolio Theory and the CAPM

rj = j + j rm + e j

for all j

Returns are composed of systematic and unsystematic components o Total Risk = Nondiversifiable Risk + Diversifiable Risk o Total Risk = Systematic Risk + Nonsystematic Risk o Total Risk = Market Risk + Nonmarket Risk o Total Risk = Market Risk + Unique Risk q In a portfolio all that matters is systematic risk The unsystematic risk is diversified away

13

Assume

E (e j ) = 0 rm and e j e j and ek

are uncorrelated are uncorrelated

Market model provides a way to ease the estimation problem in portfolio selection With Wi h a 100 asset problem we must estimate 5050 variances and covariances bl i i d i With the market model we can calculate all the variances and covariances by estimating 201 parameters

2 2 = 2 m + e2j j j 2 jk = j k m
14

The market model helps us understand why beta is the correct measure of risk in the CAPM
2 2 2 p = p m + x 2 e2 j j
j

where p = x j j
j

If we diversify it imples y p
2 2 2 p p m

In a portfolio all that matters is systematic risk Unsystematic risk is diversified away
15

Diversification Eliminates Unique Risk Not Market Risk

16

The Market Model and Performance Measurement Alphas

The intercept of the market model is a measure of abnormal performance, i.e., the alpha or the distance of a security from the SML Sometimes the market model is written in raw return form, other times it is written in excess return form Sometimes it is also called the characteristic line equation of a security

(r r ) =
i f

+ i ( rm rf ) + ei

17

Extensions of the CAPM

The Zero-Beta CAPM If investors cannot borrow or lend at the same riskfree rate, there are three possibilities: there is no riskfree asset th is riskfree lending, but no riskfree borrowing there i i kf l di b t i kf b i there is riskfree lending at one rate and riskfree borrowing at a higher rate g In expected return beta space In all three cases, risky securities plot on the security market line (SML). The only change is that the anchor of the SML is a zero-beta rate not the riskfree rate.

18

Zero-Beta CAPM Expected return standard deviation space Without a riskfree asset, there is no capital market line. With riskfree lending and no riskfree borrowing, the capital market line extends from the riskfree asset to the lending tangency portfolio The market portfolio lies above the portfolio. lending tangency portfolio tangency on the efficient frontier of risky assets and the zero-beta rate is greater than the riskfree l di rate. i kf lending With riskfree borrowing and lending at different rates, there is no capital market line, the market portfolio lies between the lending tangency portfolio and the borrowing tangency portfolio, and the zero-beta rate lies between the borrowing and lending rates rates.
19

Efficient Frontier with different borrowing and lending rates

20

Without a riskfree rate: Investors cannot trade on CML

21

A Multiperiod CAPM p

The original CAPM and the zero-beta CAPM are single period models Merton extended the CAPM in a multiperiod continuous-time framework M t model allows for the opportunity set (the riskfree Mertons d l ll f th t it t (th i kf rate, the mean vector, and the covariance matrix) to change over time If opportunities change over time, investors may want to hedge against unfavorable shifts in the opportunity set M t model relates expected returns to market betas and Mertons d l l t t d t t k tb t d the betas of hedge fund portfolios, i.e., portfolios that hedge against unfavorable shifts in the opportunity set
22

Other Extensions of the CAPM Include h f I l d other forms of i f investor risk attitudes such as power ik i d h utility (and linear risk tolerance utility) investors rather than mean-variance investors Include consumption rather than returns or wealth The risk measures of these models differ from beta, but the basic intuition is the same: a security whose payoffs are negatively correlated with wealth (or consumption) is worth more than one whose payoffs are positively correlated with wealth (or consumption) Include labour income and non-traded assets and most recently include liquidity the ease and speed with which an security can be sold at fair market value in a timely fashion
23