The Capital Asset Pricing Model (CAPM)

CAPM links the expected (excess) returns on a risky asset to its risk in an efficient portfolio The expected excess return on a risky asset or a portfolio of assets is its expected return over and above the riskfree return A portfolio is said to be efficient if among all possible portfolios with the same excess return it has the lowest variance
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The CAPM
Consider a portfolio consisting of assets i = 1, 2....N A necessary condition for a portfolio to be efficient is
E( r* - r) i = for all i = 1,2... N *) cov(r*, rp i

where ri* and rp* denote, respectively return on asset i and the portfolio
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The CAPM
The numerator is the contribution of asset i to the portfolio's excess return while the denominator is the contribution of asset i to the portfolio's variance or risk The parameter is known as the investor's relative risk aversion and is a measure of his or her attitude towards risk

The CAPM
Two fund theorem" says that in equilibrium all
investors will hold some combination of the riskfree asset and the so-called "tangency portfolio" One of the crucial ingredients in the CAPM is the notion of Market Portfolio Now let rp be the market portfolio. Denote the return on market portfolio by rm For the market portfolio to be efficient we must have

E(r* - r) i = for all i = 1,2... N *) cov(r*, rm i

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The CAPM
This can be written as follows
*) E(r* - r) = cov(r*, rm i i
* 2 E(ri - r) = m im 2 m

(1)

(2)

When (2) is applied to the market portfolio

E(rm* - r) = 2m

(3)

The CAPM
Rewriting = [E(rm* - r)/m2] Replace [ m2] by E(rm* - r) and recall the definition of the beta of asset i to get E(ri* - r) = i E(rm* - r) This is the one country CAPM The only source of systematic risk is the market risk.

The CAPM
im denotes the covariance between the returns on asset i and the market portfolio and m2 denotes the variance of the return on the market portfolio The expression [im/m2] is the familiar "Beta" of the asset i, denoted i which measures the covariance of asset i with the market portfolio

The CAPM
The parameter i is estimated by means of a regression of realized historical returns on asset i on the realized historical returns on the market portfolio ri* = i + i rm* + ui OLS estimator of i = Cov (ri*, rm*)/Var (rm*)

Sharpe and Copper (1972) Study

Test of whether shares with higher betas carry higher returns. New York Stock Exchange, time period: 1931-1967. Construct portfolios with different betas 1. First regressing individual asset returns on market returns (based on five years). 2. Once a year all shares were divided into ten categories ranked by their beta. 3. A portfolio for each category was formed (equally weighted). 4. Investment strategy: hold shares in one category only, over the entire period (1931-1967). 5. Regress portfolio return on its beta: Ri = a1 + a2bi + i They find a1=5.54 and a2=12.75.

Sharpe and Copper (1972) Study Conclusions:

Shares with higher betas generate higher returns: a2>0. Buying shares with higher forecasted betas lead to holding portfolios with higher betas (i.e. betas are stable over time). More than 95% in the variation in expected return explained by differences in beta (looks as if there is a linear relationship between beta and realized average return). The intercept greater than riskless rate of return (5.54>2%). The slope (a2) is smaller than the market premium.

Lintner
First regression Rit = i + biRmt + eit yearly returns, 301 common stocks, 19541963 Second regression Ri = a1 + a2bi + a3S 2ei + i S 2ei is the variance of the fitted residual from the first regression. If the standard CAPM is true then a1 should equal Rf, a2 should equal Rm-Rf, and a3 should equal zero. If the Zero-Beta CAPM is true then a1 should equal Rz, a2 should equal (Rm-Rz ) and a3 should equal zero. The result was a1 = 0.108 a2 = 0.063 a3 = 0.237 (both a2 and a3 are significantly different from zero at the 0.01 level) Seems to violate the CAPM!

When to use the one-country CAPM?

When national markets are completely segmented. Market portfolio of assets held by investors in a country is same as portfolio of assets issued by corporations in that country Only locals hold local assets & locals hold only local assets Not true in most countries.

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The International CAPM

Extending One Country CAPM
If resident investors hold exclusively assets issued by resident firms and foreign investors are not allowed to hold domestic assets then that countrys capital market is fully segmented from the global capital market Capital markets of most countries are certainly not fully segmented Are global capital markets fully integrated? 13 What is the relevant market portfolio?

The International CAPM

Where there are no restrictions whatsoever on investors in a country holding foreign assets and foreign investors investing in domestic assets, that global capital markets are fully integrated at least in a legal sense. There could be informational asymmetries Consider the portfolio consisting of all the stocks issued by all the firms in such an integrated world the world market portfolio CAPM requires the further assumption that all investors must have identical expectations regarding the performance of any risky asset. Otherwise they would not agree on the composition of the tangency portfolio.
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The International CAPM

For any risky asset investors would compute the real return measured in their own currencies If PPP does not hold, would investors from different countries agree on the real return from a given risky asset? If not, the ICAPM must take account of exchange rate risk in addition to the covariance risk with the world market benchmark portfolio Investors in a given country would choose their portfolios in the light of their estimates of expected returns, variances of returns and covariances measured in their reference currency, their home currency
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The International CAPM

In a multi-currency portfolio the following parameters are relevant Expected excess return on a portfolio, measured in some numeraire currency xiE(ri* - r) where xi is the share of asset i, ri* is its return measured in the numeraire currency and r is the risk-free rate in the numeraire currency Variance of portfolio returns p2 = cov(xiri*,rp*) = xicov(ri*,rp*) which in turn depends upon

(1) Pair-wise co-variances of individual market returns

(2) Pair-wise co-variances between exchange 16 rates

The International CAPM

(3) Covariance between stock market returns and changes in the exchange rate between the numeraire currency and other currencies cov(xiri*, i) where i is the proportionate change in the spot rate of currency i with respect to the numeraire currency The remaining parameters viz. expected values and variances of i do not enter portfolio choice because the portfolio weights xi are not affected by them The total variance of portfolio returns can be attributed to return variances, exchange rate varinces and covarinces between returns and exchange rate changers. Contributions of each vary according to 17 currency composition and whose point of

International CAPM
A Two Country CAPM: Ignore inflation Consider a German investor computing returns on various assets in terms of his home currency EUR. Denote by S the USD/EUR exchange rate.: (1) A US T-bill : rGE = rUS + where rUS is the return in USD terms. Thus correlation between rGE and is +1. (2) What about a US stock? (3) What about a German stock?
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An appreciation of the dollar against the Euro will increase euro return for a given dollar return.
However, will it help or hurt the valuation of the US firm? A US exporter firm export sales might decline due to appreciation. But interest and labour costs might also decline. Net impact? On balance correlation between S and return on US stocks measured in EUR positive or negative?

What about a German firm? EUR depreciation might help if strong US market presence. Costs might increase. Net impact again ambiguous.
Many empirical studies using firm-level data from do not show up an exchange rate factor in stock returns after the market factor is included.
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The International CAPM

Incorporating exchange rate risk: A two-country model ri = i + i + ui where ri denotes the EUR return on an asset i, the coefficient i will equal cov[ri , ]/var() which is a measure of asset i's covariation with the changes in exchange rate US T-bill: positive; US stocks : negative? German stocks : positive?

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The International CAPM

A Two Country CAPM
Extending the one-country CAPM, the equilibrium expected excess return on asset i measured in EUR is given by E[ri - r] = cov[ri ,rW] + cov[ri ,] The parameters and are prices of world market and exchange rate covariance risks, and rW is the return on the world market portfolio measured in EUR and r is the risk-free rate in EUR (e.g. German T-bills).
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The International CAPM

Two benchmark portfolios : (1) The world market portfolio and (2) The foreign riskless asset To operationalise the two country CAPM we must estimate and Consider the world market portfolio E[rW - r] = cov[rW ,rW] + cov[rW , ] = var[rW] + cov[rW , ] Consider a foreign i.e. US T-bill E[r* + - r] = cov[, rW] + cov(,) = cov[ , rW] + var() r*: Risk-free rate in the other currency (e.g.USD) 22 These two equations can be used to estimate

E(rW r) = var(rW) + cov(rW, )

E(r* + r) = cov (, rW] + var()

var (rW)
cov (, rW) =

cov (rW, )
var()

E(rW r) E(r* + r)
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var(rW)
cov (, rW) =

cov (rW, ) -1
var()

E(rW r)
E(r* + r)

The two sources of risk: World Market & Exchange Rate

The asset now has two betas correlation with world market and with the exchange rate.
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The International CAPM

Resulting two-country CAPM is E(ri r) = i (rW r) + i E(r* + r) Assets' beta and gamma have to be jointly estimated from a multiple regression with historical data ri = i + i rW + i + ui

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The OLS estimates are

i = var(rw) cov(rw, ) -1 cov(ri, rw)

cov(rw, )

var()

cov(ri, )

Recall that E(ri r) = [cov (ri, rw) cov (ri, )]

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Substitute for [ ]
var(rW) cov (rW, ) -1 E(rW r)

cov (, rW)
=

var()

E(r* + r)

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E(ri r) = cov (ri, rw) var(rW) cov (rW, ) -1 cov (ri, ) cov (, rW) Which leads to E(ri r) = [ i i ] E(rW r) E(r* + r) var()

E(rW r) E(r* + r)

This is the two-country CAPM

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The International CAPM

Extension to a multi-country CAPM E[(r*)iH - rH] = iE[(r*)W - rH] + i1E[1+rF1-rH] + i2E[2+rF2-rH]....+ iKE[K+rFK-rH] Here rH denotes riskfree rate in investor's currency, rF1..rFK are riskfree rates in foreign currencies 1... K are the changes in exchange rates of these currencies measured as units of home currency per unit of foreign currency .K and 1 ..

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The International CAPM

The parameters i, i1 ... iK have to be obtained from a multiple regression with historical data (r*)iH = i + i(r*)W + i1 1 + ...+ iK K + ui Global Capital Markets: Segmented or Integrated

Is the underlying assumption of no constraints on cross-border capital flows valid?

Even if legal barriers are eliminated informational barriers may remain; withholding taxes may also lead to segmentation

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The International CAPM

The evidence from empirical testing of the ICAPM tests lead to the conclusion that international capital markets are not fully integrated Volatility clustering has been observed in almost all national stock markets There are volatility spillovers between stock markets and between the forex and the stock market.

Estimation of Risk Premia

To use the ICAPM for asset pricing we need to estimate the beta and gammas for the asset and the risk premia E[(r*)W - rH], E[1+rF1-rH]... E[K+rFK-rH]
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