MS 60:

Financial Markets & Investment Analysis Week VI:

The Capital Asset Pricing Model
Copyright Prentice Hall Inc. 1999. Author: Nick Bagley
Key Topics to Cover
-The Capital Asset Pricing Model in Brief
- Determining the Risk Premium on the Market
Portfolio
- Beta and Risk Premiums on Individual
Securities
-Using the CAPM in Portfolio Selection
-CAPM & Valuation
INTRODUCTION ( cont)
Key question it seeks to answer: What
would risk premiums on securities be in
equilibrium if people had the same set of
forecasts of expected returns and risks and
all chose their portfolios optimally according
to the principles of diversification
Market does not reward investors for holding
inefficient portfolios, hence rewards only a
securitys contribution to risk of an efficiently
diversified portfolio
BETA () & RISK PREMIUMS ON
SECURITIES (cont)
CAPM:
E(rj) = rf + j*( E(rm) rf ), rj = return on asset i, Rf is risk free rate, rm
is the return on the market and Bj is the correlation between the return
on asset j and the markets return.


Formula for risk premium in CAPM =
E(rj) rf = j*( E(rm) rf )
This is called the Security Market Line (SML)
Slope of the SML is the risk premium on the market portfolio. Hence if
the risk premium is 0.8 then E(rj) rf = 0.8* j

According the the CAPM, in equilibrium, the risk premium on any
asset is equal the product of
| (or Beta)
the risk premium on the market portfolio


Comment: | = 1
A security with a | = 1 on average rises
and falls with the market
a 10% (say) unexpected rise (fall) in the
market return premium will, on average, result
in a 10% rise (fall) in the securitys return
premium
Comment: | > 1
A security with a | > 1 on average rises
and falls more than the market
With a | = 1.3, a 10% (say) unexpected rise
(fall) in the market return premium will, on
average, result in a 13% rise (fall) in the
securitys return premium
Such a security is said to be aggressive
Comment: | s 1
A security with a | s 1 on average rises
and falls less than the market
With a | = 0.7, a 10% (say) unexpected rise
(fall) in the market return premium will, on
average, result in a 7% rise (fall) in the
securitys return premium
Such a security is said to be defensive
Security Market Line
The plot of a securitys risk premium (or sometimes
security returns) against security beta
Note that the slope of the security market line is the
market premium
By CAPM theory, all securities must fall precisely on
the SML (hence its name)
Security Market Line
With A Zero-Beta Portfolio
E(R)
E(R
m
)
|
i

SML
M
0.0 1.0
E(R
z
)
E(R
m
) - E(R
z
)
Security Market Line
Market
Portfolio
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
-2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0
Beta (Risk)
E
x
p
e
c
t
e
d

R
i
s
k

P
r
e
m
i
u
m
Relationship Between
Systematic Risk and Return
Sharpe and Cooper: positive, but non-linear
Douglas: intercept higher than the risk-free rate
Miller and Scholes: possible error in Douglas
findings
Black, Jensen, and Scholes: positive linear
relationship between monthly excess return and
portfolio beta
Fama and McBeth: supported the CAPM with
the intercept equal to the RFR
Relationship Between
Systematic Risk and Return
Effect of skewness on the relationship
preference for high risk and returns
Effect of size, P/E and leverage
Effect of book-to-market value
The Fama-French Study
Observation
All securities, (not just efficient portfolios)
plot onto the SML, if they are correctly
priced according to the CAPM
The Beta of a Portfolio
When determining the risk of a portfolio
using standard deviation results in a formula
thats quite complex
using beta, the formula is linear

= + + + =
+ + +
i
r i r n r r r w r w r w
i n n n
w w w w | | | | | ...
2 1 2 2 1 1
2 1 ...
( ) ( )
2
1
,
, 1
2
...
2
2 2 1 1
|
|
.
|

\
|
+ =

> =
+ + +
j i
j i r r j i
n i
r i r w r w r w
j i i n n
w w w o o o o
Computing Beta
Here are some useful formulae for
computing beta
f M
f r
i
M
M i i
M
M i M i
M
M i
M i i
r
r
i

=
= = = =

|
o
o
o
o o
o
o
| |
,
2
,
2
,
,
CAPM & PORTFOLIO
SELECTION
CAPM provides a rationale for a simple passive portfolio
strategy:
Diversify your holdings of risky assets in the proportions of
the market portfolio
Mix this portfolio with the risk-free asset to achieve a
desired risk-reward combination
Provides a basis of determining, given a desired rate of return,
what is the necessary risk that an investor has to accept
Provides a risk-reward benchmark to evaluate investment
advisors, i.e. relate returns on portfolio to its riskiness. Use
SML

Using the CAPM in Portfolio
Selection
Whether or not CAPM is a valid theory,
indexing is attractive to investors because
historically it has performed better than most
actively managed portfolios
it costs less to implement that active
management
The Portfolio Manager
The further a well diversified portfolio
consistently lies above (below) the SML,
the better (worse) the fund managers
performance
Valuation Using CAPM
Beta may be used to obtain the discount factor/Required Return
on Capital for a new project as follows:
Assume Patty Shop is financed by 20% short-term debt, and
80% equity, and its | is 1.3 (assume debt is risk-free)
Its optimal capital structure is 40% (risk-free) debt, and 60%
equity
VALUATION & REGULATING RATES
OF RETURN -USES
From Discounted cash flow valuation models:
P0(Equity) = d1 / ( r g) where, r, can be expressed as: r = rf +
*((rm) rf)
Cost of equity capital: E(ri) = rf + i*(rm) rf)
CAPM can be used to determine a fair rate of return
Assume the market rate is 15%, and the risk-free rate is 5%
Lets First Compute the Beta for Patty Shop as follows:

04 . 1
0 * 20 . 0 3 . 1 * 80 . 0
bond
=
+ =
+ =
company
company
bond equity equity company
w w
|
|
| | |
Valuation Using CAPM
The Beta of Patty Shop is equal to the beta of the new
Project
To find the required return on the new project, apply the
CAPM
( )
( )
% 4 . 15
05 . 0 15 . 0 04 . 1 05 . 0
=
+ =
+ =
f m f
r r r Knew |
MODIFICATION & ALTERNATIVES
TO CAPM
Why deviations to simple CAPM model:
Poor data
Market imperfections
Need more realistic model ( Intertemporal CAPM )
Alternative models:Arbitrage Pricing Model(APT)
Use a number of variables, e.g. inflation, economic growth
etc. to derive a model based on more complex variables
Relaxing the Assumptions
of the CAPM
Heterogenous expectations
If all investors have different expectations about
risk and return, each would have a unique CML
and/or SML, and the composite graph would be
a band of lines with a breadth determined by the
divergence of expectations
Planning periods
CAPM is a one period model, and the period
employed should be the planning period for the
individual investor, which will vary by individual,
affecting both the CML and the SML
Criticism of CAPM by Richard Roll
Limits on tests: only testable implication
from CAPM is whether the market portfolio
lies on the efficient frontier
Range of SMLs - infinite number of
possible SMLs, each of which produces a
unique estimate of beta
Criticism of CAPM by Richard Roll
Market efficiency effects - substituting a
proxy, such as the S&P 500 creates two
problems
Proxy does not represent the true market
portfolio
Even if the proxy is not efficient, the market
portfolio might be
Criticism of CAPM by Richard Roll
Conflicts between proxies - different
substitutes may be highly correlated
even though some may be efficient and
others are not, which can lead to
different conclusions regarding beta
risk/return relationships
So, CAPM is not testable - but it still has
value and must be used carefully
Stephen Ross devised an alternative
way to look at asset pricing - APT
Arbitrage Pricing Theory - APT
Arbitrage is a process of buying a lower
priced asset and selling a higher priced
asset, both of similar risk, and capturing the
difference in arbitrage profits
The general arbitrage principle states that
two identical securities will sell at identical
prices
Price differences will immediately disappear
as arbitrage takes place
Arbitrage Pricing Theory- APT
Arbitrage Pricing Theory - APT
Three major assumptions:
1. Capital markets are perfectly
competitive
2. Investors always prefer more wealth
to less wealth with certainty
3. The stochastic process generating
asset returns can be expressed as a
linear function of a set of K factors or
indexes
Arbitrage Pricing Theory - APT
N i b b b E Ri
i k ik i i i
to 1 for
2 2 1 1
= e + + + + + = o o o
assets of number
error) (random return s ' asset on effect unique a
assets all of returns the influences mean that
zero a with indexes or factors common of set a
index or factor comon
a in movements to returns s ' asset in reaction
changes zero have indexes
or factors the all if asset for return expected
period time specified a during asset on return
=
= e
=
=
=
=
N
i
K K
i b
i E
i Ri
i
k
ik
i
o
Roll-Ross Study
1. Estimate the expected returns and the
factor coefficients from time-series data on
individual asset returns
2. Use these estimates to test the basic
cross-sectional pricing conclusion implied
by the APT
Extensions of the
Roll-Ross Study
Cho, Elton, and Gruber examined the
number of factors in the return-generating
process that were priced
Dhrymes, Friend, and Gultekin (DFG)
reexamined techniques and their
limitations and found the number of factors
varies with the size of the portfolio
The APT and Anomalies
Small-firm effect
Reinganum - results inconsistent with the APT
Chen - supported the APT model over CAPM
January anomaly
Gultekin - APT not better than CAPM
Burmeister and McElroy - effect not captured by
model, but still rejected CAPM in favor of APT
APT and inflation
Elton, Gruber, and Rentzler - analyzed real returns
The Shanken Challenge to
Testability of the APT
If returns are not explained by a model, it is not
considered rejection of a model; however if the factors do
explain returns, it is considered support
APT has no advantage because the factors need not be
observable, so equivalent sets may conform to different
factor structures
Empirical formulation of the APT may yield different
implications regarding the expected returns for a given
set of securities
Thus, the theory cannot explain differential returns
between securities because it cannot identify the relevant
factor structure that explains the differential returns
Alternative Testing Techniques
Jobson proposes APT testing with a
multivariate linear regression model
Brown and Weinstein propose using a
bilinear paradigm
Others propose new methodologies