I.4.

3 The Capital Asset Pricing Model

FIN 357: I.4.43 The Valuation of Risky Cash Flows c 2001 DC

Investors Preferences
In order to develop a theory which allows us to price stocks, we will have to start by understanding the demand for risky securities, i.e. how investors choose their portfolios. In doing so, we will assume that when choosing between alternative portfolios investors only care about the portfolios expected return and risk, as measured by the standard deviation of the portfolios return. In particular, it seems reasonable to assume that investors prefer more money to less, and hence like higher expected returns, but dislike risk (i.e. they are risk-averse). This implies that their indierence curves, when plotted in the mean-standard deviation space are upward sloping: to keep an investor indierent, an increase in risk must be accompanied by an increase in expected return.
rp

Increasing utiliy

FIN 357: I.4.44 The Valuation of Risky Cash Flows c 2001 DC-SG

Investors Preferences (contd)

When are these indierence curves useful at all? In some cases we do not need them to rank stocks. For example, suppose we only have two stocks with r1 = 0.15, r2 = 0.10, 1 = 0.2, and 2 = 0.3. This situation is depicted in the left-hand side gure below. In this case, it is quite obvious that stock 1 is preferred to stock 2 (by everybody) as its expected return is higher (r1 > r2 ), but stock 1s return is less risky (1 < 2 ). What about the case where r1 = 0.10, r2 = 0.15, 1 = 0.2, and 2 = 0.3, which is depicted in the right-hand side gure? Without indierence curves, we cannot tell which stock is preferred by whom.
20%

20%

15%

15%

rp
10% 2

rp
10% 1

5% 10%

20%

30%

40%

50%

5% 10%

20%

30%

40%

50%

FIN 357: I.4.45 The Valuation of Risky Cash Flows c 2001 DC-SG

Investors Preferences
The left-hand side gure below shows the indierence curves for a hypothetical investor. Clearly, if this investor could only invest in one stock or the other, he would choose the second stock, as it lies on a higher indierence curve. However, another investor with dierent indierence curves could prefer the rst stock, as the right-hand side gure shows.
20% 20%

15%

15%

rp
10% 1

rp
10% 1

5% 10%

20%

30%

40%

50%

5% 10%

20%

30%

40%

50%

We will see that these investors (i) can in fact do better by diversifying, i.e. by choosing a portfolio composed of both stocks; (ii) will eventually agree on which stocks to pick.
FIN 357: I.4.46 The Valuation of Risky Cash Flows c 2001 DC-SG

Choosing Stock Portfolios

Recall that if w1 denotes the proportion invested in the rst stock, then the expected return on a portfolio of the two stocks is given by rp = w1 r1 + (1 w1 )r2 and its risk by p =
2 2 2 w1 1 + (1 w1 )2 2 + 2w1 (1 w1 )12 1 2 .

The following curve shows the combinations of mean and standard deviation available to the investor by forming portfolios of the two assets. The optimal portfolio for the investor is at the tangency point of his indierence curve with the portfolio opportunity set.
20%

15%

2 1

rp
10%

portfolio opportunity set

5% 10%

20%

30%

40%

50%

FIN 357: I.4.47 The Valuation of Risky Cash Flows c 2001 DC-SG

Choosing Stock Portfolios (contd)

If there are N risky assets, instead of just two, the general shape of the portfolio opportunity set is unaltered; however, there are an innite number of attainable points in the interior of the set. r
p

stocks

The portfolios on the boundary of the set are called minimum-variance portfolios and are characterized by the fact of having the minimum standard deviation (or variance) for a given expected return. We can therefore trace out the minimum-variance frontier by solving the following problem for dierent values of r:
N w1 ,w2 ,... ,wN N

minimize

2 p = i=1 j=1 N

wi wj ij
N

subject to

rp =
i=1

wi ri = r,
i=1

wi = 1.

FIN 357: I.4.48 The Valuation of Risky Cash Flows c 2001 DC-SG

Example: International Portfolio Selection

As an example, let us look at the minimum-variance frontier from investing in international stock markets. The following table illustrates the required information:
Exp. Ret. USA CAN BEL FRA GER ITA NET SWI JAP UK 13.7 18.3 12.5 14.4 12.5 19.7 17.4 13.0 11.3 17.2 Std. Dev. 14.9 20.8 16.3 18.4 13.5 28.4 18.4 11.8 11.4 17.0 Correlation Coecients USA CAN BEL FRA GER ITA NET SWI JAP UK 1.00 .78 .11 .27 .37 .12 .28 .50 .34 .46 1.00 .09 1.00 .19 .41 1.00 .33 .30 .28 1.00 .29 .08 .19 .04 1.00 .35 .38 .31 .52 .43 1.00 .56 .36 .38 .59 .20 .49 1.00 .32 .30 .23 .36 .21 .45 .37 1.00 .51 .34 .31 .47 .40 .45 .58 .55 1.00

FIN 357: I.4.49 The Valuation of Risky Cash Flows c 2001 DC

Example: International Portfolio Selection (contd)

25%

20%

ITA

Expected Returns

15%

JAP

10%

UK NET FRA SWI USA GER BEL

CAN

5%

0% 0%

5%

10%

15% 20% Standard Deviation

25%

30%

FIN 357: I.4.50 The Valuation of Risky Cash Flows c 2001 DC

Choosing Stock Portfolios (contd from p.I.4.48)

Notice that investors would only be interested in those portfolios that lie along the upper part of the minimum-variance frontier. These are called ecient portfolios. Ecient portfolios oer the highest expected return for any given level of risk.
rp
individual 2 individual 1

Again, the investors optimal portfolio would be at the tangency point of his indierence curves with the ecient frontier.

FIN 357: I.4.51 The Valuation of Risky Cash Flows c 2001 DC-SG

The Eect of Borrowing and Lending

Now suppose that in addition to being able to invest in the N risky stocks, our investor can also borrow and lend at some risk-free interest rate rf . By investing a proportion w in a portfolio of risky stocks with expected return rS and standard deviation S and a proportion (1 w) in the riskless asset, the investor can obtain an expected return of rp = wrS + (1 w)rf and a standard deviation of p =
2 w2 S + (1 w)2 0 + 2w(1 w) 0 = |w|S .

The following gure shows the set of mean-standard deviation combinations that the investor can obtain for dierent values of w.
rp
lending at riskfree rate borrowing at riskfree rate

w>
S

rS

<w
rf w=

<

w=

FIN 357: I.4.52 The Valuation of Risky Cash Flows c 2001 DC-SG

The Eect of Borrowing and Lending (contd)

Now consider combining borrowing and lending with dierent stock portfolios.
rp
best
bette r

rm rf

S2 S1

better

Clearly, the best portfolios are those along the solid line: they oer the highest expected return for each level of risk. Thus, with riskless borrowing and lending the ecient frontier is a straight line. This line is also called the Capital Market Line (CML), because it represents the best trade-o available in the market between risk and return. Its equation is rp = rf + rm rf p m

FIN 357: I.4.53 The Valuation of Risky Cash Flows c 2001 DC-SG

The Capital Market Line

Regardless of their tastes for risk (i.e. indierence curves), all investors prefer investing some of their money in portfolio M, combined with some borrowing or lending at the riskfree rate. The portfolios between (0, rf ) and (m , rm ) on the Capital Market Line involve lending at the riskfree rate (e.g. portfolio A), whereas the portfolios on the rest of that line involve borrowing at the riskfree rate (e.g. portfolio B).
rp

rm rf

M
A

The important thing to remember is that the portfolio of risky assets chosen by every investor is portfolio M. Also, in the presence of a riskfree asset, the Capital Market Line represents the set of all ecient (well-diversied) portfolios.
FIN 357: I.4.54 The Valuation of Risky Cash Flows c 2001 DC-SG

The Equilibrium Price of Risk: A Numerical Example

Suppose that there are only three risky assets in the economy: IBM, Ford and AT&T. Suppose that the equilibrium (current) price of their shares are $60, $80, and $50 respectively. The following table shows the total market capitalization of these three companies: Price per Shares Company share outstanding 1. IBM $60 50 million 2. Ford $80 25 million 3. AT&T $50 20 million Total value of stock market Market capitalization $3 billion $2 billion $1 billion $6 billion Fraction of market 1/2 1/3 1/6

So the total supply of risky assets is a portfolio of $6 billion with weights of 1/2, 1/3 and 1/6 on IBM, Ford and AT&T respectively. Suppose that there are only two investors in this economy. This means that they are holding the entire supply of risky assets, namely the whole $6 billion.

FIN 357: I.4.55 The Valuation of Risky Cash Flows c 2001 DC-SG

The Equilibrium Price of Risk: Numerical Example (contd)

Furthermore, we know that the two investors will choose the same portfolio of risky assets (even though they may choose to invest a dierent amount in that portfolio). This portfolio consists of a fraction w1 in IBM, w2 in Ford, and w3 in AT&T. This implies that the total demand for the shares of IBM, Ford and AT&T by the two investors is ($6 billion w1 ), ($6 billion w2 ) and ($6 billion w3 ) respectively. Suppose for a moment that w1 = w2 = w3 = 1/3. How much money is invested in each of the companies? Demand Company portfolio 1. IBM 1/3 2. Ford 1/3 3. AT&T 1/3 Total demand Dollar demand $2 billion $2 billion $2 billion $6 billion

Obviously, this cannot be an equilibrium, since demand is not equal to supply.

FIN 357: I.4.56 The Valuation of Risky Cash Flows c 2001 DC-SG

The Equilibrium Price of Risk: Numerical Example (contd)

The only portfolio that will make demand equal to supply is: w1 = 1/2, w2 = 1/3, and w3 = 1/6. Demand Company portfolio 1. IBM 1/2 2. Ford 1/3 3. AT&T 1/6 Total demand Dollar demand $3 billion $2 billion $1 billion $6 billion

This shows that, in equilibrium, the portfolio demanded by the investors must correspond to the portfolio supplied by the companies.

FIN 357: I.4.57 The Valuation of Risky Cash Flows c 2001 DC-SG

The Equilibrium Price of Risk

We have seen that all investors, regardless of their preferences would choose portfolios along the CML: in other words, all investors would buy the same portfolio M of risky assets, and then borrow or lend to achieve the combination of risk and return they prefer. Now what must portfolio M look like? Since every investor is holding the same portfolio M of risky assets, M must be the market portfolio: the portfolio composed of all risky assets held according to their relative market valueyou can think of it as being well approximated by the S&P500 portfolio. Recall that the equation of the CML is rp = rf + rm rf p . m

Over the period 19261988 the mean excess return on the S&P500 (rm rf ) has been 8.4% and its standard deviation (m ) 20.9%. Therefore, the slope of the CML is about 0.4. This represents the equilibrium price of risk: for a well-diversied (ecient) portfolio, the market demands an excess return of 0.4% for every percentage point of risk (standard deviation).
FIN 357: I.4.58 The Valuation of Risky Cash Flows c 2001 DC

The CAPM
The CML gives the trade-o between risk and return for ecient portfolios: rm rf rp = rf + p . m For these well-diversied portfolios, the standard deviation (p ) measures the market risk (i.e. there is no unique risk, as it is diversied away). This means that we can rewrite the CML as rm rf expected return = rf + (market risk of portfolio). m Individual securities will typically be inecient, and will not lie on the CML. Instead, they lie below it: rm rf ri < rf + i . m However, it turns out that the relationship between expected return and market risk also holds for individual securities. Also, we will see that for an individual security the correct measure of market risk is given by i m , where i im 2 m

FIN 357: I.4.59 The Valuation of Risky Cash Flows c 2001 DC-SG

The CAPM (contd)

The general relationship between risk and return is therefore given by ri = = rf + rm rf (market risk of security i) m rm rf rf + (i m ) m

ri = rf + (rm rf )i This is the Capital Asset Pricing Model (CAPM). According to the CAPM, the expected return on any asset or portfolio should plot on the following line, called the Security Market Line (SML).
rp rm rf
M

FIN 357: I.4.60 The Valuation of Risky Cash Flows c 2001 DC-SG

The Intuition behind the CAPM

Why is the market risk i m the appropriate measure of risk of an asset? The reason is that investors hold well-diversied portfolios. Some of the total risk i of the asset will be eliminated by diversication. Therefore, there is no reason for the investor to demand a compensation for this risk. The only risk that matters is the additional risk that the security contributes to an investors portfolio. Since every investor holds the market portfolio, the relevant risk is the contribution of an asset to the risk of the market portfolio. Now, the risk m of the market portfolio can be written as m =
2 m = m N N i=1 N j=1

wi wj Cov(i , rj ) r m
N

=
i=1

wi

Cov(i , r

N j=1

wj rj )

=
i=1

wi

im = m

wi
i=1

im m = 2 m

wi i m .
i=1

Therefore we see that i m is the correct measure of the risk of asset i. Why then is p an appropriate measure of risk for an ecient portfolio?

FIN 357: I.4.61 The Valuation of Risky Cash Flows c 2001 DC

The CML vs SML

It is important to remember that the CML holds for ecient portfolios only; the SML holds for any stock/security/portfolio (including ecient portfolios). The following gure illustrates the relationship between the CML and the SML.
rp
CML

rp
SML

rB rm r rf
M
1

rB rm r rf
M
1

m
Portfolio B's market risk

m
Security 1's unique risk

Portfolio B's total risk

Security 1's market risk

p [total risk]

[(market risk) /m ]

FIN 357: I.4.62 The Valuation of Risky Cash Flows c 2001 DC-SG

Properties of Betas
The beta of stock i is the slope coecient in the following regression ri = i + i rm + i .
~ ri

i
~ rm

You can then see that the beta measures the sensitivity of a stock price to market movements. Stocks with betas higher than 1 tend to amplify the overall movements of the market. Stocks with betas between 0 and 1 tend to move in the same direction as the market, but not as far.

FIN 357: I.4.63 The Valuation of Risky Cash Flows c 2001 DC-SG

Properties of Betas (contd)

For the market portfolio, we have m = mm = 1. 2 m

The beta of a portfolio is a weighted average of the individual securities betas p = Cov( pm = 2 m
N i=1 wi ri , rm ) 2 m N

=
i=1

wi

im = 2 m

wi i .
i=1

FIN 357: I.4.64 The Valuation of Risky Cash Flows c 2001 DC-SG

Proof of the CAPM

It is easy to see that all portfolios obtained combining the risk-free asset with the market portfolio should lie on the SML. Indeed, for these portfolios, rp = wrm + (1 w)rf so that rp = p rm + (1 p )rf = rf + (rm rf )p . But what about an arbitrary asset or portfolio? Consider security I, which plots below the SML. Since the market portfolio is on the SML, if there is a stock that plots below the SML, there must also exists a stock J that plots above the SML.
rp rm rf
M P I
(This figure is repeated on page I.4.66)

and

p = w 1 + (1 w) 0 = w,

FIN 357: I.4.65 The Valuation of Risky Cash Flows c 2001 DC

Proof of the CAPM (contd)

rp rm rf
M P I
(This is the same figure as on page I.4.65)

Now would you hold security I at all? The answer is no, as you would be better o dropping security I from your portfolio and replacing it with a share of portfolio P (a combination of the riskless asset and stock J): by doing this you would increase the expected return of your portfolio without increasing the risk. However, this would create excess demand for stock J and excess supply for stock I. Consequently, in equilibrium all assets (and portfolios) must plot on the SML.

FIN 357: I.4.66 The Valuation of Risky Cash Flows c 2001 DC

The CAPM: Example I

The expected return of the market portfolio is 16% and its standard deviation is 20%. The T-bill rate is 6%. (i) What is the expected return of an ecient portfolio that has a standard deviation of 10% ? (ii) What is the expected return of a security that has a beta of 0.7? (iii) What is the covariance between the return of a security and the return of the market if the beta of the security is 0.8? (iv) What is the correlation between the return of a security and the return of the market if the standard deviation of the security is 0.4 and its expected return is 0.25? First write the information that is given: rm = 0.16, m = 0.2 and rf = 0.06.

FIN 357: I.4.67 The Valuation of Risky Cash Flows c 2001 DC-SG

The CAPM: Example I (contd)

FIN 357: I.4.68 The Valuation of Risky Cash Flows c 2001 DC-SG

The CAPM: Example II

The expected return on a portfolio that combines the T-bill and the market portfolio of risky assets is 25%. The T-bill rate is 5%, the expected return on the market portfolio of risky assets is 20%, and the standard deviation of the above portfolio is 4%. What is the expected return of a security that has a corelation of 0.5 with the market and a standard deviation of 2%?

FIN 357: I.4.69 The Valuation of Risky Cash Flows c 2001 DC-SG

The CAPM: Example II (contd)

FIN 357: I.4.70 The Valuation of Risky Cash Flows c 2001 DC-SG

The CAPM: Example II (contd)

FIN 357: I.4.71 The Valuation of Risky Cash Flows c 2001 DC-SG

What Determines Betas?

The CAPM allows us to determine a stocks expected returns given the stocks beta. But what determines the beta of a stock? Probably the most important factor determining a companys beta is the systematic risk of the cash ows generated by its assets (the asset beta). Industry Drilling oil and gas wells Electronic components Air Transportation Retail department stores Motor vehicle parts

Asset 1.90 1.30 1.30 1.12 1.01

Industry Food Textiles Telephone companies Grocery Stores Electric utilities

Asset 0.96 0.93 0.84 0.74 0.56

Source: U.S. Federal Energy Regulatory Commission Hearing and 1984 CRSP Data (*).

Why do you think the asset beta of the food industry is so large?

FIN 357: I.4.72 The Valuation of Risky Cash Flows c 2001 DC-SG

What Determines Betas? (contd)

Another strong factor is the amount of nancial leverage. To see this, let Assets denote the assets beta. Since this is just the same as the beta of a portfolio including all the rms debt and all its equity, we have Assets = or D Equity = Assets + (Assets Debt ) E D E Debt + , D+E D + E Equity

FIN 357: I.4.73 The Valuation of Risky Cash Flows c 2001 DC-SG

Example of a Beta Table

FIN 357: I.4.74 The Valuation of Risky Cash Flows

The Rationale for Adjusted Betas

It has been shown that betas estimated from past data tend to revert to 1, the market beta, over time. Betas 195461 0.57 0.71 0.88 0.96 1.03 1.13 1.24 1.32

Portfolio 1 2 3 4 5 6 7 8

194754 0.36 0.61 0.78 0.91 1.01 1.13 1.26 1.47

196168 0.72 0.79 0.88 0.92 1.04 1.02 1.08 1.15

Source: M. Blume, Betas and Their Regression Tendencies, Journal of Finance, 1975.

To properly account for this tendency, investment banks often adjust their estimated to an adjusted . For example, an invetment bank has been known to use the following adjustment: 1 2 = + (1). 3 3
FIN 357: I.4.75 The Valuation of Risky Cash Flows c 2001 DC-SG

Review of the CAPM

The CAPM is a theory that explains how the expected return of a security is related to its risk. The logical steps of its derivation are as follows: Suppose that investors only care about the expected return and risk (standard deviation) of their portfolios: in particular, they prefer higher expected return and lower risk. Investors will then look at all possible portfolios to pick up the one they most prefer. In general, they will hold dierent portfolios depending on their preferences. However, if all investors have the same information and can borrow and lend at the same riskless rate rf , then all investors will hold the same portfolio of risky assets M : what varies according to the individual preferences is simply how the investors split their wealth between this fund and the riskless asset. Since all investors hold the same portfolio of risky assets M , in equilibrium M must be the market portfolio. This implies that the appropriate measure of risk for a security is its market risk, i.e., that fraction of risk that cannot be diversied away. In turn, this implies a linear relationship between expected returns and market risk (betas).
FIN 357: I.4.76 The Valuation of Risky Cash Flows c 2001 DC

Review of the Assumptions Underlying the CAPM

The following assumptions were implicitly made in deriving the CAPM Investors choose their portfolios based on expected return and variance. All investors have identical subjective estimates of the means, variances and covariances of all assets. Investors trade in perfect capital markets. This means that there are no frictions such as taxes, transaction costs, or restrictions on short sales; there is no dierential between borrowing and lending rates; all asset are perfectly divisible. Investors are price takers and do not try to inuence prices. The supply of all assets is given.

FIN 357: I.4.77 The Valuation of Risky Cash Flows c 2001 DC

Empirical Tests of the CAPM

Several assumptions of the CAPM are rather restrictive. However, the true test of any theory is how well it ts the data. The CAPM is usually tested by estimating the following regression rit rf = a + bi + it . If the CAPM is true, then 1. The intercept a should be zero. 2. The coecient b should equal rm rf . 3. The assets beta should be the only factor that explains expected returns: if other terms (such as residual variance, dividend yield, rm size, price-earnings ratios, ratio of book to market value of the rm, or beta squared) are added to the regression, they should have no explanatory power.

FIN 357: I.4.78 The Valuation of Risky Cash Flows c 2001 DC

Empirical Tests of the CAPM (contd)

There have been hundreds of tests of the CAPM. With a few exceptions, they agree on the following conclusions: Returns are linearly related to betas, with a positive slope. Variations of the model which include a squared beta term or unsystematic risk nd that these factors are dominated by betas. The intercept term a is signicantly greater than zero and the slope b is less than rm rf . For example, the following graph illustrates the result of a study by Black, Jensen and Scholes (1972), who estimated the Security Market Line using the average monthly excess return on 10 portfolios including all available NYSE stocks over the period 19311965.
3% Average Monthly Excess Return

2% Market Portfolio

1%

Empirical SML

SML

0% 0 0.5 1 1.5 Systematic Risk (Beta) 2

FIN 357: I.4.79 The Valuation of Risky Cash Flows c 2001 DC

Empirical Tests of the CAPM (contd)

The message from the empirical evidence reported so far is that the qualitative conclusion of the CAPM is well supported by the data: expected returns are linearly related to assets betas. However, quantitative conclusion on the value of the coecients is rejected. Some studies have reported stronger evidence against the CAPM: factors other than beta seem to be successful in explaining the portion of security returns not captured by beta. Basu (1977) found that low price/earnings portfolios have higher returns than what the CAPM would predict. Banz (1981) and Reiganum (1981) found that smaller rms tend to have higher returns. Litzenberger and Ramaswamy (1979, 1982) found that the market requires higher rates of return on stocks with high dividend yields. Keim (1983) found evidence that stock returns are seasonal. One possible explanation for such ndings is that measurement errors in betas are systematically related to these additional factors. Rosenberg and Marathe (1977) have indeed found that betas can be forecasted much better if variables such as dividend yield, trading volume and rm size are added to the predictive model.
FIN 357: I.4.80 The Valuation of Risky Cash Flows c 2001 DC