CAPM

Capital Asset Pricing Model

By Martin Swoboda and Sharon Lu

Introduction
Modern Portfolio Theory and diversification Beta vs. standard deviation Unsystematic vs. systematic risk Security Market Line (SML) The CAPM equation Asset pricing Assumptions behind using CAPM

Modern Portfolio Theory and diversification

Rational investors use diversification to optimize their portfolios Diversification reduces portfolio risk

(assets that are not perfectly correlated) Efficient Portfolio

Beta vs. standard deviation

Standard deviation includes systematic and unsystematic risk; not used because unsystematic risk diversified away

Beta: A standardized measure of the risk of an individual asset, one that captures only the systematic component of its volatility; measures how sensitive an individual security is to market movements; measure of market risk

Unsystematic vs. systematic risk

Unsystematic risk: risk that can be eliminated through diversification

a.k.a. Unique risk, residual risk, specific risk, or diversifiable risk

Systematic risk: risk that cannot be eliminated through diversification

a.k.a, market risk or undiversifiable risk

Security Market Line

Line representing the relationship between expected return and market risk; shows expected return of an overall market as a function of systematic risk Graphical representation of CAPM Compare a single asset to the SML (and see if it falls below, above, or on the line)

Security Market Line

Capital Asset Pricing Model (CAPM)

The expected return on a specific asset equals the risk-free rate plus a premium that depends on the assets beta and the expected risk premium on the market portfolio.
Expected return of specific asset: E(Ri) Risk-free rate: Rf Expected risk premium: E(Rm) - Rf

Practice Problem #1

If the risk-free rate equals 4% and a stock with a beta of 0.8 has an expected return of 10%, what is the expected return on the market portfolio?

Practice Problem #1: answer

If the risk-free rate equals 4% and a stock with a beta of 0.75 has an expected return of 10%, what is the expected return on the market portfolio? 10% = 4% + 0.75(market portfolio 4%) 8% = market portfolio 4% 12% = market portfolio

Practice Problem #2

A particular asset has a beta of 1.2 and an expected return of 10%. Given that the expected return on the market portfolio is 13% and the risk-free rate is 5%, the stock is: A. appropriately priced B. underpriced C. overpriced

Practice Problem #2: answer

A particular asset has a beta of 1.2 and an expected return of 10%. Given that the expected return on the market portfolio is 13% and the risk-free rate is 5%, the stock is: A. appropriately priced B. underpriced C. overpriced; expected return should be 14.6% (5+1.2(13-5))

Asset pricing
Future cash flows of the asset can be discounted using the expected return calculated from CAPM to establish the price of the asset If observed price > CAPM valuation overvalued (paying too much for that amount of risk) If observed price < CAPM valuation undervalued

Assumptions behind the CAPM

U.S. treasuries are risk-free Uncertainty about inflation Assumed that investors can borrow money at same interest rate at which they lend, but generally borrowing rates are higher than lending rates WHY we still use CAPM: benchmark portfolios used Treausry bills and market portfolio

Practice Problem #3
Last year Firm A: return: 10%, beta: 0.8 Firm B: return: 11%, beta: 1.0 Firm C: return: 12%, beta: 1.2 Given that the risk-free rate was 3% and market return was 11%, which firm had the best performance?

Practice Problem #3: answer

Firm A: 3% + 0.8(11%-3%) = 9.4% (over) Firm B: 3% + 1.0(8%) = 11% (same) Firm C: 3% + 1.2(8%) = 12.6% (under)

Firm A performed the best because it exceeded the expected return