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Objectives:

relationships between co-variance and market.

By now CAPM must be clear to you, so that will help you while understanding this

lesson: “THE SECURITY MARKET LINE (SML)”. After completion of this lesson

you will get better idea about CAPM.

The Capital Market Line represents the equilibrium relationship between the expected

return and standard deviation for the efficient portfolios. Individual risky securities will

always plot below the line because a single risky security when held by it is an inefficient

portfolio. The Capital Asset Pricing Model does not imply any particular relationship

between the expected return and the standard deviation (that is, total risk) of an individual

security. To say more about the expected return of an individual security, deeper analysis

is necessary.

Following is the equation for calculating the standard deviation of any portfolio:

1/ 2

N N

σP= Σ Σ X i X j σ ij 1

i=1 j=1

where Xi and Xj denoted the proportions invested in securities i and j, respectively, and

denoted the covariance of returns between security and i and j. Now consider using this

equation to calculate the standard deviation of the market portfolio.

N N 1/ 2

σM = Σ Σ XiM XjM σij 2

i=1 j=1

where XiM and XjM denote the proportions invested in securities i and j in forming the

market portfolio, respectively. It can be shown that another way to write the above

equation is as follows:

N N N

σM = X1M Σ XJM σ1j + X2M Σ XJM 2j + X3M Σ Xjm 3j 3

j=1 j=1 j=1

N 1/ 2

+ ............. + XNM Σ Xjm σNj

j=1

At this point a property of covariance can be used: the covariance of security i with the

market portfolio (σim) can be expressed as the weighted average of every security’s

covariance with security i:

j=1

This property, when applied to each one of the N risky securities in the market portfolio,

results in the following:

Where σ1M denotes the covariance of security 1 with the market portfolio, σ2M denotes

the covariance of security 2 with the market portfolio, and so on. Thus the standard

deviation of the market portfolio is equal to square root of a weighted average of the

covariance of all securities with it, where the weights are equal to the proportions of the

respective securities in the market portfolio.

At this juncture an important point can be observed. Under the CAPM, each

investor holds the market portfolio and is concerned with its standard deviation because

this will influence the slope of the CML and hence the magnitude of his or her investment

in the market portfolio. The contribution of each security to the standard deviation of the

market portfolio can be seen Equation 5 to depend on the size of its covariance with the

market portfolio. Accordingly each investor will note that the relevant measure of risk for

a security is its covariance with the market portfolio, σim . This mean that securities with

larger values of σim will be viewed by investors as contributing more to the risk of the

market portfolio. It also means that securities with larger standard deviations should not

be viewed as necessarily adding more risk to the market portfolio than those securities

with smaller deviations.

From this analysis it follows that securities with larger values for have to provide

proportionately larger expected returns to interest investors in purchasing them. To see

why consider what would happen if such securities did not provide investors with

proportionately larger levels of expected return. In this situation, these securities would

contribute to the risk of the market portfolio. This means that deleting such securities

from the market portfolio would cause the expected return of the market portfolio relative

to its standard deviation to rise. Because investors would view this as a favorable change,

the market portfolio would no longer be the optimal risky portfolio to hold. Thus security

prices would be out of equilibrium.

The exact form of the equilibrium relationship between risk and return can be

written as follows:

rm - r f

ri = rf + ---------- σ iM 6

σ 2M

As you can see in panel (a) of Figure A, Equation 6 represents a straight line having a

vertical intercept of rf and a slope of [(rm – rf ) σ2 m /]. As the slope is positive, the

equation indicates that securities with larger covariance with the market (σim) will be

prices so as to have larger expected returns (ri). This relationship between covariance and

expected return is known as the Security Market Line (SML).

Interestingly, a risky security with σim = 0 will have an expected return equal to

the rate on the riskfree security, rf. Why? Because this risky security, just like the riskfree

security, does not contribute to the risk of the market portfolio. This is so even though the

risky has a positive standard deviation whereas the riskfree security deviation of zero.

Figure A

It is even possible for some risky securities (meaning securities with positive

standard deviations) to have expected returns less than the risk free rate. According to the

CAPM, this will occur if σim < 0, thereby indicating that they contribute a negative

amount of risk to the market portfolio to be lower than it would be if less money cause

the risk of the market portfolio to be lower than it would be if less money were invested

in them).

Also of interest is the observation that a risky security with σim = σ2 im will have

an expected return equal to the expected return on the market portfolio rm, This is because

such a security contributes an average amount of risk to the market portfolio.

Another way of expressing the SM is follows;

ri = rf + (rM – rf ) βiM 7

where the term is defined as:

σiM

βiM = ---------- 8

σ2M

The term is known as the beta coefficient (or simply the beta) for security i, and is an

alternative way of representing the covariance of a security. Equation 7 is a different

version of the SML as can be seen in panel (b) of Figure A. Although having the same

intercept as the earlier version shown in Equation (6). rf, it has a different slope. The

slope of this version is (rm - rf), whereas the slope of the earlier version was [(rm - rf )/

σ2m].

One property of beta is that the beta of a portfolio is simply a weighted average of

the betas of its component securities, where the proportions invested in the securities are

the respective weights. That is, the beta of a portfolio can be calculated as:

i=1

Earlier it was shown that the expected return of a portfolio is a weighted average

of the expected returns of its component securities, where the proportions invested in the

securities are the weights. This means that because every security plots on the SML, so

will every portfolio. To put it more broadly, not only every security but also every

portfolio must plot on an upward-sloping straight line in a diagram with expected return

on the vertical axis and beta on the horizontal axis. This means that efficient portfolios

plot on both the CML and the SML, although inefficient portfolios plot on the SML, but

below the CML.

Also of interest is that the SML must go through the point representing the market

portfolio itself. Its beta is 1 and its expected return is rm, so its co-ordinates are (1, rm ).

Because riskfree securities have beta value of 0, the SML will also go through a point

with an expected return of rf and coordinates of (0, rf). This means that the SML will have

a vertical intercept equal to rf and a slope equal to the vertical distance between these two

points(rm - rf) divided by the horizontal distance between these two points (1 – 0) or (rm -

rf)/(1 – 0) = (rm - rf). Thus these two points suffice to fix the location of the SML,

indicating the appropriate expected returns for securities and portfolios with different

beta values.

The equilibrium relationship shown by the SML comes to exist through the

pressures on security prices. Given a set of security prices, investors calculate expected

returns and covariance and then determine their optimal portfolios. If the number of

shares of a security collectively desired differs from the number available, there will be

upward or downward pressure on its price. Given a new set of prices, investors will

reassess their desires for the variances securities. The process will continue until the

number of shares collectively desired for each security the number available.

For the individual investor, security prices and prospects are fixed while the

quantities are fixed (at least in the short run), and prices are variable. As in any

competitive market, equilibrium requires the adjustment of each security’s price until

there is consistency between the quantity desired and the quantity available.

whether or not securities have been priced in equilibrium as suggested by the CAPM.

However, the issue of whether or not such testing of the CAPM can be done in a

meaningful manner is controversial. For at least some purposes, affirmative test results

may not be necessary to make practical use of the CAPM.

An Example is as follows:

If you refer the example in the last lesson, just try to recall, Able, Baker, and Charlie

were shown to form the market portfolio in proportions equal to .12, .19 and .69

respectively. Given these proportions, the market portfolio was shown to have an

expected return 22.4% and a standard deviation 15.2%. The risk free rate in the example

was 4%. Thus for this example the SML, as indicated in Equation (6) is:

rm - r f (6)

ri = rf + --------- σim

σ2m

22.4 – 4

= 4 + ----------- σim

(15.2)2

The following expected return vector and variance covariance matrix can be used

in this examples as:

ER = 24.6 VC = 187 854 104

22.8 145 104 289

At this point, the co variances of each security with the market portfolio can be calculated

by using Equation (4). More specifically, the co variances with the market portfolio for

Able, Baker, and Charlie are equal to:

3

i=1

= (.12 x 146) + (.19 x 187) + (.69 x 145)

= 153

3

i=1

= (.12 x 187) + (.19 x 854) + (.69 x 104)

= 257

3

i=1

= (.12 x 145) + (.19 x 104) + (.69 x 289)

= 236.

You just note how the SML as given in Equation (10) states that the expected return for

Able should be equal to 4 + (0.08 x 153) = 16.2%. Similarly, the expected return for

Baker should be 4 + (.08 x 257) = 24.6%, and the expected return for Charlie should be 4

+ (.08 x 236) = 22.8%. Each one of these expected returns corresponds to the respective

value given in the expected return vector.

Alternatively, Equation (8) can be used to calculate the betas for the three

companies. More specifically, the betas for Able, Baker, and Charlie are equal to:

σ1M

β1M = ------

σ2m

153

= -----

(15.2)2

= .66

σ2M

β2M = ------

σ2m

257

= -----

(15.2)2

= 1.11

σ3M

β3M = ------

σ2m

236

= -----

(15.2)2

= 1.02.

Now equation (7) indicated that the SML could be expressed in a form where the

measure of risk for an asset was its beta. For the example under consideration, this

reduces to:

ri = rf + (rM-rf) βiM

= 4 + (22.4 – 4) βiM

= 4 + 18.48 βiM (11)

Note how the SML as given in this equation states that the expected return for Able

should be equal to 4 + (18.4 x .66) = 16.2%. Similarly, the expected return for Baker

should be 4 + ( 18.4 x 1.11) = 24.6%, and the expected return for Charlie should be 4 +

(18.4 x 1.02) = 22.8%. Each one of these expected returns correspond to the respective

value given in the expected return vector.

It is important to realize that if any other portfolio is assumed to be the market

portfolio, meaning that if any set of proportions other than .12, .19 and .69 is used, then

such an equilibrium relationship between expected returns and betas (or covariance) will

not hold. Consider a hypothetical market portfolio with equal proportions (that is, .333)

invested in Able, Baker and Charlie. Because this portfolio has an expected return of

21.2% and a standard deviation of 15.5%, the hypothetical SML would be as follows:

rm - r f

ri = rf + --------- σiM

σ2m

21.2 - 4

= 4 + ----------- σiM

(15.5)2

= 4 + .07 σiM.

σ1m = ΣX jM σ1j

j=1

= 159,

which means that Able’s expected return according to the hypothetical SML should be

equal to 15.1% = 4 + (0.70 x 159). However because this does not correspond to the

16.2% figure that appears in the expected return vector, a portfolio with equal proportions

invested in Able, Baker, and Charlie cannot be the market portfolio.

Market model assumes the return on a common stock was to be related to the return on a

market index in the following manner.

ri = αiI + βiI rI + ∈iI (1)

rI = return on market index for the same period,

αiI = intercept term,

βiI = slope term,

∈iI = random error term.

It is but natural to think about the relationship between the market model and the Capital

Asset Pricing Model. After all, both models have a slope term called “beta” in them, and

both models somehow involve the market. However, there are two significant differences

between the models.

model where the factor is a market index. Unlike the CAPM, however, it is not an

equilibrium model that describes how prices are set for securities.

Second, the market model utilizes a market index such as the S$P 500, where as

the CAPM involves the market portfolio. The market portfolio is a collection of all the

securities in the marketplace, whereas a market index is in fact based on a sample of the

market broadly construct (for example, 500 in the case of the S&P 500). Therefore,

conceptually the beta of a stock based on the market model, βiI, differs from the beta of

the stock according to the CAPM, βiM. This is because the market model beta is measured

relative to a market index while the CAPM beta is measured relative to the market

portfolio. In practice, however, the composition of the market portfolio is not precisely

known, so a market index is used. Thus while conceptually different, betas determined

with the use of a market index are treated as if they were determined with the use of the

market portfolio. That is, βiI is used as an estimate of βiM.

In the example, only three securities were in existence – the common stocks of

Able, Baker, and Charlie. Subsequent analysis indicated that the CAPM market portfolio

consisted of these stocks in the proportions of .12, .19 and .69, respectively. It is against

this portfolio that the betas of the securities should be measured. However, in practice

they are like to be measured against a market index (for example, one that is based on just

the stocks of Able and Charlie in proportions of .20 and .80 respectively).

Market Indices

One of the most widely known indices is the Standard & Poor’s Stock Price Index

(referred to earlier as the S&P 500), a value-weighted average price of 500 large stocks.

Complete coverage of the stocks listed on the New York Stock Exchange is provided by

the NYSE. Composite Index, which is broader than the S&P 500 in that it considers more

stocks. The American Stock Exchange computes a similar index for the stocks it lists, and

the National Association of Security Dealers provides an index of over-the-counter stocks

traded on the Nasdaq system. The Russell 3000 and Wilshire 5000 stock indices are the

most comprehensive indices of U.S. common stock prices published regularly in the

United States. Because they consist of both listed and over-the-counter stocks, they are

closer than the others to representing the overall performance of American stocks.

Without question the most widely quoted market index is the Dow Jones Industrial

Average (DJIA). Although based on the performance of only 30 stocks and utilizing a

less satisfactory averaging procedure, the DJIA provides at least a fair idea of what is

happening to stock prices. Table 10.1 provides a listing of the 30 stocks whose prices

have been reflected in the DJIA.

The total risk of a security could be partitioned into two components as follows –

σ2i = β2i1 σ21 + σ2εi (2)

where the components are:

σ2 = unique risk.

Because beta, or covariance, is the relevant measure of risk for a security

according to the CAPM, it is only appropriate to explore the relationship between it and

the total risk of the security. It turns out that the relationship is identical to that given in

Equation (2) except that the market portfolio is involved instead of a market index.

As with the market model, the total risk of security i, measured by its variance and

denoted σ2i, is shown to consist of two parts. The first component is the portion related to

moves of the market portfolio. It is equal to the product of the square of the beta of the

stock and the variance of the market portfolio, and also often referred to as the market

risk of the security. The second component is the portion not related to moves of the

market portfolio. It is denoted σ2 ∈i and can be considered non-market risk. Under the

assumptions of the market model, it is unique to the security in question and hence is

termed unique risk. Note that if is treated as an estimate of βim , then the decomposition

of σ2i is the same in equation (2) and (3).

An Example

From the earlier example, the betas of Able, Baker, an Charlie were calculated to be .66,

1.11 and 1.02, respectively. As the standard deviation of the market portfolio was equal

to 15.2%, this means that the material risk of the three firms is equal to (.662 x 15.22) =

100, (1.112 x 15.22) = 285, and (1.022 x 15.22) = 240, respectively.

The non-market risk of any security can be calculated by solving equation (3) for

σ2 ∈i

Thus, Equation (10.13) can be used to calculate the non-market risk of Able, Baker,

and Charlie, respectively,

= 46

σ2∈2 = 854 – 285

= 569

σ2∈3 = 289 – 240

= 49.

taking the square root of σ2 ∈i and would be equal to √46 = 6.8% for Able, √568= 23.9%

for Baker, and √49=7% for Charlie.

At this point one may wonder: why partition total risk into two parts? For the investor, it

would seem that risk is risk- whatever its source. The answer lies in the domain of

expected returns.

Market risk is related to the risk of the market portfolios and to the beta of the

security in question. Securities with larger betas will have larger amounts of market risk.

In the world of the CAPM, securities with larger betas will have larger expected returns.

These two relationships together imply that securities with larger market risks should

have larger expected returns.

Non-market risk is not related to beta. This means that there is no reason why

securities with larger amounts of non-market risks should have larger expected returns.

Thus according to the CAPM, investors are awarded for bearing market but not bearing

non-market risk. You try to solve the following problems and questions.

QUESTIONS AND PROBLEMS

1. Describe the key assumptions underlying the CAPM.

2. Many of the underlying assumptions of the CAPM violated to some degree in the

“real world”. Does the fact invalidate the model’s conclusions? Explain.

3. What is the separation theorem? What implications does it have for the optimal

portfolio of risky assets held by investors?

4. What constitutes the market portfolio? What problems does one confront in

specifying the composition of the true market portfolio? How have researchers

and practitioners circumvented these problems?

5. In the equilibrium world of the CAPM, is it possible for a security not to be part

of the market portfolio? Explain.

6. Describe the price adjustment process that equilibrates the market’s supply and

demand for securities. What conditions will prevail under such an equilibrium?

7. Will an investor who owns the market portfolio have to buy and sell units of the

component securities every time the relative prices of those securities change?

Why?

8. Given an expected return of 12% for the market portfolio, a riskfree rate of 6%,

and a market portfolio standard deviation of 20%, draw the Capital Market Line.

9. Explain the significance of the Capital Market Line.

10. Assume that two securities constitute the market portfolio. Those securities have

the following expected returns, standard deviations, and proportions:

Expected Standard

Security Return Deviation Proportion

A 10% 20% 40

B 15 28 60

Based on this information, and given a correlation of .30 between the two securities and

riskfree rate of 5%, specify the equation for the Capital Market Line.

11. Distinguish between the Capital Market Line and the Security Market Line.

12. The market portfolio is assumed to be composed of four securities. Their

covariances with the market and their proportions are shown below:

Covariance

Security with market Proportion

A 242 .20

B 360 .30

C 155 .20

D 210 .30

Given this data, calculate the market portfolio’s standard deviation.

13. Explain the significance of the slope of the SML. How might the slope of the

SML change over time?

14. Why should the expected return for a security be directly related to the security’s

covariance with the market portfolio?

15. The risk of a well-diversified portfolio to an investor is measured by the standard

deviation of the portfolio’s returns. Why shouldn’t the risk of an individual

security be calculated in the same manner?

16. A security with a high standard deviation of returns is not necessarily highly risky

to an investor. Why might you suspect that securities with above-average standard

deviations tend to have above-average betas?

17. Oil Smith, an investments student, argued, “A security with a positive standard

deviation must have an expected return greater than the riskfree rate. Otherwise,

why would anyone be willing to hold the security?” Based on the CAPM, is Oil’s

statement correct? Why?

18. Kitty Bransfield owns a portfolio composed of three securities. The betas of those

securities and their proportions in Kitty’s portfolio are shown on the next page.

What is the beta of Kitty’s portfolio?

Security Beta Proportion

A .90 .30

B 1.30 .10

C 1.05 .60

19. Assume that the expected return on the market portfolio is 15% and its standard

deviation is 21%. The riskfree rate is 7%. What is the standard deviation is 2%.

The riskfree rate is 7%.What is the standard deviation of a well-diversified (no

non-market-risk) portfolio with an expected return of 16.6%?

20. Given that the expected return on the market portfolio is 10%, the riskfree rate of

return is 6%, the beta of stock A is .85, and the beta of stock B is 1.20:

a. Draw the SML.

b. What is the equation for the SML?

c. What are the equilibrium expected returns for stocks A and B?

d. Plot the two risky securities on the SML?

21. You are given the following information on two securities, the market portfolio,

and the riskfree rate:

Correlation

Expected with market Standard

Return Portfolio Deviation

Security 1 15.5% 0.90 20.0%

Security 2 9.2 0.80 9.0

Market Portfolio 12.0 1.00 12.0

Riskfree Rate 5.0 0.00 0.0

a. Draw the SML.

b. What are the betas of two securities?

c. Plot the two securities on the SML?

22. The SML describes an equilibrium relationship between risk and expected return.

Would you consider a security that plotted above the SML to be an attractive

investment? Why?

23. Assume that two securities, A and B, constitute the market portfolio. Their

proportions and variances are .39, 160, and .61, 340, respectively. The covariance

of the two securities is 190. Calculate the betas of two securities.

24. The CAPM permits the standard deviation of a security to be segmented into

market and non-market risk. Distinguish between the two types of risk.

25. Is an investor who owns any portfolio of risky assets other than the market

portfolio exposed to some non-market risk? Explain.

26. Based on the risk and return relationship of the CAPM, supply values for the

seven missing data in the following table.

Expected Standard Non-market

Security Return Beta Deviation Risk (σ2 ∈i )

A ______% 0.8 _______% 81

B 19.0 1.5 _______ 36

C 15.0 ____ 12 0

D 7.0 0 8 _______

E 16.6 _____ 15 _______

27. (Appendix Question) Describe how the SML is altered when the riskfree

borrowing rate exceeds the riskfree lending rate.

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