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The CAPM
Dong Lou
London School of Economics
• The CAPM
• Measuring betas
• Use of the CAPM
• Empirical evidence on the CAPM
• Multifactor models
How does the investor choose?
Increasing
Return utility for
risk averse
investor
Low Risk High Risk
High Return High Return
Risk
Efficient Frontier
Return
Portfolio Return rT
T
.
Efficient Portfolio
Risk Free
rf
Return
Risk
The Capital Asset Pricing Model
• Assumptions:
– There are N stocks and one riskless asset in the
economy (i.e., lending and borrowing at a single
riskless rate);
– Each investor holds a mean-variance efficient
portfolio, i.e., a portfolio with the highest expected
return given volatility;
– Investors have a one-period horizon;
– Investors have the same beliefs;
– Market clears, i.e., demand = supply.
The Capital Asset Pricing Model
Return
Market Return rM
M
.
Efficient Portfolio
Risk Free
rf
Return
Risk
CAPM: derivation by intuition
2∆Cov ( rj , rM )
– Hence, the return/risk gain is:
∆ ( E ( rj ) − rf ) ( E ( rj ) − rf )
=
2∆Cov ( rj , rM ) 2Cov ( rj , rM )
– This must be the same for all assets. Why?
CAPM: derivation by intuition
• Suppose that for two assets A and B:
E (rA ) − rf E (rB ) − rf
>
Cov(rA , rM ) Cov(rB , rM )
Expected
Return
Expected
Market
Return
Expected
market risk
premium
Risk free
rate
Rate of Return
on Stock A Slope = Beta
x x
x
x x
x x x
x
x
x x Rate of Return
on the Market
x x
x
Jan 1995
Measuring Betas
Dell Computer
R2 = .10
B = 1.87
Dell Computer
R2 = .27
B = 1.61
General Motors
GM return (%)
Price data: May 91- Nov 97
R2 = .07
B = 0.72
General Motors
GM return (%)
Price data: Dec 97 - Apr 04
R2 = .29
B = 1.21
( ) [
E rj = r f + β j E( rM ) − r f ]
SML
Required
return
13
Company Cost
of Capital
5.5
0
Project Beta
1.26
Testing the CAPM
30
SML
Empirical SML
20
10
Market
Portfolio
0
Portfolio Beta
1.0
Testing the CAPM
Empirical SML
20
10 Market
Portfolio
0
Portfolio Beta
1.0
Testing the CAPM
30
10
Market
0 Portfolio
Portfolio Beta
1.0
Empirical evidence on the CAPM
• Is CAPM dead?
– Theory says that true betas are related to average returns.
FAt = RM,t – rf
FBt = Rsmall,t – Rbig,t.
FCt = Rhigh,t – Rlow,t.
Dollars
(log scale)100
1
1926
1936
1946
1956
1966
1976
1986
1996
2003
0.1
Multifactor Pricing Models