Topic 6 The Capital Asset Pricing Model (CAPM)

Copyright of Spanish version from David Moreno

Translation into English by Francisco Romero

Universidad Carlos III Financial Economics Teacher: Beatriz Mariano

Topic 6- The Capital Asset Pricing Model (CAPM) Outline

1.
1. 2. 3. 4. 5.

THE CAPITAL ASSET PRICING MODEL

Assumptions and foundations of the model The CML (Capital Market Line) The SML (Security Market Line) The Beta () The Beta () of a portfolio

1- Assumptions and foundations of the model

The CAPM (Capital Asset Pricing Model) is fundamental for modern finance, even though it was developed 50 years ago. The CAPM was developed by William Sharpe (1962). He received the Nobel Prize.. It is a model that works when financial markets are equilibrium. Therefore, Supply=Demand The CAPM builds on the Markowitz mean-variance model .
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1- Assumptions and foundations of the model

The CAPM is a theoretical model and therefore it is based on assumptions:
a)

b)

c) d) e) f)

g)

It is a static model; economic agents only focus on what happens one period ahead (1 quarter ahead, 1 year ahead etc.) Perfect competition in financial markets. There are many investors (each with a different utility function and initial wealth). Furthermore, investors are price takers. Risky financial assets are perfectly divisible and supply is exogenous. The same interest rate applies to lending and borrowing. There are no transaction costs and taxes. Investors optimize according to Markowitz theory (i.e. care about meanvariance trade-off). Investors share the same information, therefore, their risk and return expectations for each asset are identical.
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2- The CML (Capital Market Line)

Given that investors share the same information and follow the mean-variance model, all choose the tangency portfolio T as te optimal portfolio of risky assets. But they differ in the percentage of his/her wealth allocated to the risk-free asset and to portfolio T.
E[Rp]

CML

Cartera ptima Cartera tangente

Tangent portfolio

Rf

Cartera ptima Investors optimal portfolio del inversor

Riesgo Risk

2- The CML (Capital Market Line)

THE MARKET PORTFOLIO COINCIDES WITH THE TANGENCY PORTFOLIO:

This is easily shown given our previous assumptions. What is the market portfolio?
The portfolio that includes all risky assets available. In equilibrium when we add together everyones holdings of portfolio T, we must have every share in every company in the market. So T is also called the market portfolio, M. The weight of asset j in the market portfolio is equivalent to the total value of asset j in the economy, divided by the total value of all risky assets in the economy.
n j Pj* Value of asset " j" Wj = = Value of the market portfolio N ni Pi*
i =1

P* represents equilibrium prices, as S =D.

2- The CML (Capital Market Line)

If every investor holds the tangency portfolio as his risky asset (obtained from the mean-variance model) and the CAPM is an equilibrium model (i.e. Excess Supply =0), then the weight of an asset in the tangent portfolio is equal to the weight of this asset in the market portfolio. EXAMPLE: suppose that the weight of TEF shares in the tangent portfolio is 23%. This means that all agents have 23% of their wealth invested in TEF shares. Therefore, if the market portfolio is the sum of all portfolios from all economic agents, TEF shares will also represent a 23% of the market. The same applies for the remaining assets.
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2- The CML (Capital Market Line)

This is why we can replace the tangency portfolio with the market portfolio in the mean-variance graph:

E[Rp]
Efficient Eficiente FronteraFrontier

CAL CML

E[Rc] Cartera ptima Market

Portfolio M
Rf

Riesgo Risk
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3- The SML (Security Market Line)

Under the CAPM agents hold diversified portfolios, hence they demand a risk premium which depends on the systematic risk of each asset (and not on specific risk). The systematic risk wdepends on , therefore, investors demand a return that will be a function of . The fundamental CAPM equation relates an assets risk premium to:
The expected market risk premium The assets systematic risk (its beta)

3- The SML (Security Market Line)

Therefore:

E [ri ] = rf + i ( E [rM ] rf ) E[ Ri ] = i ( E [rM ] rf )

Risk premiums are represented by capital letters:

rM-rf=RM Market Risk Premium E(ri)-rf=Ri Asset i Risk Premium

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3- The SML (Security Market Line)

Example: Under the CAPM assumptions, determine AMADEUS shares expected return taking into account that next year expected market return is 11.5%, one-year t-bills offer a return of 3.5%, and AMADEUS is 1.8. 1. Is the expected return on shares of AMADEUS higher than the expected return of the market? 2. Determine the expected return on shares of Amadeus.
Answers:

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3- The SML (Security Market Line)

CAPM derivation: Assume a portfolio p with proportion a of wealth in asset i and porportion (1-a) in the market portfolio. The risk and return of portfolio p is:
E[rp ] = (1 a ) E [rM ] + aE [ri ]
2 r = [(1 - a) 2 M + a 2 i2 + 2a(1- a) i , M ]
p

1/ 2

Different portfolios are generated by changing the weight a. These portfolios are represented by the curve I-I.
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3- The SML (Security Market Line)

(I-I) is tangent to the CML in M (where a=0)

At point M, the slope of I-I and the slope of the CML are the same.

To calculate the slope at M:

E[rp ] = E[ri ] E[rM ] a

(rp ) 1 2 = (1 a) 2 M + a 2 i2 + 2a (1 a ) i , M 2 a

] [2a
1/ 2

2 M

2 2 M + 2a i2 + 2 i , M 4a i , M

]
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3- The SML (Security Market Line)

For a=0.
E[rp ] = E[ri ] E[rM ] a a =0
2 (rp ) i,M M 1 2 1/ 2 2 = [ ] [ 2 M + 2 i ,M ] = a a =0 2 M M

The slope of I-I at M is:

E[rp ] a (rp ) a
=
a =0

E[ri ] E[rM ] 2 i,M M

Equating the slopes of I-I and of the CML at point M (as done previously): E[r ] r E[ r ] E[ r ]
M f

i ,M M

M 2 M

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3- The SML (Security Market Line)

Then:
2 i ,M M E[ ri ] E[ rM ] = ( E[rM ] r f ) 2 M

Given that:

i =

i ,M 2 M

E[ ri ] = E[rM ] + ( E[ rM ] r f )( i 1) E[ ri ] = r f + i ( E[rM ] r f )

This is the CAPM basic expression. We can represent graphically the expected return required (in equilibrium) for holding a asset depending on its systematic risk SML (Security Market Line)
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3- The SML (Security Market Line)

The relationship between expected return and systematic risk is represented by the SML.
E[ri]

Can an asset be represented outside the SML?

SML

E[rM]

rf

BM=1

Bi

Slope of SML = market risk premium

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4- The Beta
The BETA: BETA As we have already seen:
Total Risk

Specific Risk

Systematic Risk

Variance

BETA

The Beta measures an assets contribution to the risk of a well diversified portfolio (or market portfolio). The Beta shows the sensitivity of an assets excess return to changes in the market return.
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4- The Beta
It can be calculated by a regression of the assets excess return on the market excess return.

ri

Ri-Rf

ri ,t = + rm ,t + i ,t
Then,

rM

Rm-Rf

Cov(ri , rm )

2 rm
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4- The Beta
Example: Determine the beta and the expected return of shares of Example TELEFON, given that the covariance between the returns of this shares and the IGBM is 0.099, the standard deviation of returns on the shares is 17%, and the standard deviation of returns on the market index (IGBM) is 24%. In addition, te return on a one-year Tbill is 4.5%, and the expected market risk premium is 8%. Answer:

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4- The Beta We can differentiate between shares according to their Betas:

Beta < 1 Beta = 1 Defensive stock

Neutral stock Aggressive stock

Beta > 1

Questions: What is the market beta or the beta of the market portfolio? What is the beta of the risk-free asset?
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5- The portfolio Beta

THE PORTFOLIO BETA: Given that the Beta measures non-diversifiable risk, the portfolio beta is the portfolio-weighted average of the betas of its individual securities.

With 2 assets

p = w11 + w2 2
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5- The portfolio Beta

Example: Suppose that an investment fund holds a portfolio with three risky assets, with the following characteristics: Asset 1: = 0.05, and portfolio weight 20%. Asset 2: = 1.02, and portfolio weight 35%. The returns of asset 3 have a covariance with the returns of the market of 0.0399. Considering that the standard deviation of returns of the market portfolio is 19%, compute the of this portfolio. Answer:

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Readings
Brealey, R.A. and Myers, S.C. (2003). Principles of Corporate Finance. McGraw Hill Chapter 8 Surez Surez, Andrs S. (2005). Decisiones ptimas de inversin y financiacin en la empresa. Ediciones Piramide. Chapters 32, 33 and 34. Brigham E.F. and Daves, P. R. (2002). International Financial Mangement. South-Western. Chapters 2 and 3. Grinblatt, M. and Titman, S. (2002). Financial Markets and Corporate Strategy. McGraw Hill Chapter 5.
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USEFUL WEBSITES
BANCO DE ESPAA:
http://www.bde.es

DIRECICIN GENERAL DEL TESORO:

http://www.tesoro.es

MERCADO AIAF:
http://www.aiaf.es

BOLSA DE MADRID
http://www.bolsamadrid.es

INVERCO
http://www.inverco.es
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