A formal derivation of CAPM based on individual assets contribution to the (risk-free) excess return and

return variance of the market portfolio

(without requiring any advanced mathematical knowledge)

Important:
This note is for your knowledge only and not examinable.
This note summarizes logic flows underlying my informal derivation of CAPM in the lecture.
It also produces a formal derivation of CAPM without advanced mathematical knowledge requirement.

1. What did I do in lecture 6 to derive CAPM informally?

The logic flow of my informal derivation in lecture 6 runs as follows:
1) I first used three slides to illustrate the idea that any assets expected return should be related to its
risk. The key is what do mean by risk here.
2) One conclusion of optimal portfolio theory in lecture 5 is: every investors final (optimal) complete
portfolio will be some combination of the risk-free asset and the optimal risky portfolio, P*. Since every
investor is holding the same P*, P* by definition is the portfolio of all risky assets held by investors. And
in equilibrium, the demand of any asset will equal to the supply (so we say the market is cleared), which
means that any risky assets available in the market must be held by some investor(s). So P* by definition
is the portfolio of all risky assets this is referred as the market portfolio (denoted as M).
3) Hence every investor is holding a portfolio comprising of the risk-free asset and the market portfolio
M. Since the risk-free asset by definition does not involve any risk, the uncertainty in an investors
investment returns (and thus the uncertainty in her wealth) is due to the variance of M.
4) So for a risky asset j, its risk to an investor is its contribution to the variance of M (if you cannot see
this based on my discussion in (3), I really cannot help any further). So the general idea that expected
return should increase in risk (which is correct in all settings, just by how you mean for risk) could be
more specifically rephrased for any asset as its contribution to the market expected return should
increase in its contribution to the market risk.
So the task now is to see what an assets contribution to the market return and market risk is.
5) We know that the return of M is: rM = j wjrj, and wj = Valuej /j Valuej
E[rM] = j wj E[rj], so asset js contribution to the market portfolios expected return is wj E[rj].
Var[rM] = Cov[rM, rM] = Cov[j wjrj, rM] = j wj Cov[rj, rM], so asset js contribution to the market portfolios
variance is wj Cov[rj, rM]
So wj E[rj] should increase in wj Cov[rj, rM].
6) However, the risk-free asset has a return of rf, even if it does not contribute anything to the market
variance, because Cov[rf, rM] = 0 .
So maybe both expected return contribution and variance contribution should be measured relative to
the risk-free asset, i.e.,
wj (E[rj] rf) should increase in wj (Cov[rj, rM] - Cov[rf, rM]) = wj Cov[rj, rM].
7) now lets further assume that this positive relationship is a linear one, i.e.,
wj (E[rj] rf) = c*{wj Cov[rj, rM]},

or
E[rj] rf = c*Cov[rj, rM]

(eq. 1)

Since I am referring to a very general asset j, it could be the market portfolio itself, i.e., the equation
above should hold also for the market portfolios return.
E[rM] rf = c*Cov[rM, rM] , by which we have
C = (E[rM] rf)/Cov[rM, rM] = (E[rM] rf)/Var[rM, rM] = (E[rM] rf)/2M

(eq. 2)

Replacing the C in equation (1) by equation (2), we have CAPM equation:

E[rj] rf = {Cov[rj, rM]/2M}*(E[rM] rf)

(eq. 3)

We normally refer to Cov[rj, rM]/2M as j (beta or CAPM beta) which measures THE RISK of asset j, and
(E[rM] rf) as the (market) risk premium, which measures THE PRICE (or REWARD) for the risk.

2. A formal derivation of CAPM

So the key premise of the above informal reasoning is:
An assets contribution to the expected market excess return should be linearly related to its
contribution to the market risk (variance of the market portfolio). Now let me show this formally and
with this, CAPM is naturally derived.
1) Again starting from lecture 5, the optimal portfolio theory tells us that: the market portfolio (M) has
the highest reward-to-risk ratio, i.e., E(rM) - rf)/2M (lets call this RtRM) among all risky assets.
Now lets see how an asset j contributes to that ratio which must be due to its contribution to the
numerator (which is the expected market excess return) and the denominator (which is the market
variance). I already showed in section 2.6) above that the two contributions are: wj (E[rj] rf) and wj
Cov[rj, rM].
Lets define asset js contribution to RtRM (denote this contribution generally as RtRcM, and for an asset j,
as RtRjM) as its contribution to the numerator of that ratio divided by its contribution to the
denominator of the ratio:
RtRjM = {wj (E[rj] rf)} / {wj Cov[rj, rM]}

(eq. 4)

You can cancel out wj in both numerator and denominator of the right-hand-side part of the above
equation, but I keep them deliberately for the convenience of proof.
2) One important observation of eq. 4 is that: the reward-to-risk ratio of the market portfolio, RtRM, is a
weighted-average value of individual assets contribution (RtRcM) to that ratio, where the weight for an
asset j is wj Cov[rj, rM]/2M.
This is because:
j { wj Cov[rj, rM]/2M }* RtRjM = j { wj Cov[rj, rM]/2M }* {wj (E[rj] rf)} / {wj Cov[rj, rM]}
= j {wj (E[rj] rf)}/2M = (E[rM] rf)/2M = RtRM
And j { wj Cov[rj, rM]/2M } = 1 so wj Cov[rj, rM]/2M indeed qualifies as weights (the weights in an
weighted average calculation should sum up to 100%).
3) Because the market portfolio has the highest RtR ratio, and RtRM is a weighted-average of all assets
contribution (RtRcM) to the ratio, it follows that any asset js RtRjM should equal to RtRM.
What if this is not the case, say RtRjM > RtRM? We can increase the investment weight (wj) of asset j in
the market portfolio, which in turn will increase the weight of asset j (wj Cov[rj, rM]/2M) in the
calculation of RtRM. This will lead to a higher RtRM this violates the conclusion that the market portfolio
has the highest RtR among all possible portfolios we can achieve with all risky assets.

How about we flip the side of the coin, what if RtRjM < RtRM? Because RtRM is a weighted average of all
assets contribution (RtRcM) to the ratio, it means that there must be at least one other asset i with its
RtRiM > RtRM. So following the similar argument above, we can increase the investment weight of asset i
in the market portfolio, and have a higher RtRM this again violates the conclusion that the market
portfolio has the highest RtR among all possible portfolios we can achieve with all risky assets.
So RtRjM == (must equal to) RtRM
Looking for the expression of RtRjM in eq. 4, we have
{wj (E[rj] rf)} / {wj Cov[rj, rM]} = RtRM = E(rM) - rf)/2M
With very minimal manipulation of the above equation, we have CAPM equation:
E[rj] rf = {Cov[rj, rM]/2M}*(E[rM] rf)
4) Further note
This derivation is essentially the non-mathematic version of the formal derivation based on the first
order derivative of RtRM with respect to wj (the formal derivation method 1 introduced at the end of
lecture note for lecture 6).
Curious students may find one of the arguments above confusing:
when RtRjM > RtRM, we can increase the investment weight (wj) of asset j in the market portfolio to
increase RtRM.
The market portfolio by definition is the portfolio of all risky assets on the market so how can you
increase the weight of asset j in the market portfolio when all available shares of asset j have already
been included in the portfolio?
Here you can think in a different way:
We want to buy more shares of asset j and add them to the market portfolio. This is impossible because
asset js supply is fixed all shares of asset j have already been held by some investor(s). As such, asset
js price must increase for this extra demand which in turn will decrease its expected return (see my
discussion in the first three slides) and thus decrease the value of its contribution to the reward-to-risk
ratio of the market portfolio, RtRjM = {wj (E[rj] rf)} / {wj Cov[rj, rM]}. This will continue until RtRjM = RtRM
(so we dont have the incentive to buy more asset j to include in the market portfolio to increase its RtR
ratio).
This different way of thinking resembles the 2nd formal derivation method presented at the end of
lecture notes. There I started with an investor holding the market portfolio, and proved that this
investor cannot improve its portfolios reward-to-risk ratio by deviating from the original market
portfolio (by buying or selling a small amount of an asset j).