CAPM1

Capital Asset Pricing Model

overview
0

Power of Diversification
Risk Nonsystematic Risk (idiosyncratic, diversifiable)

Portfolio Risk
Market Risk

Systematic Risk

Number of Stocks
1 1

Market Portfolio

The Market Portfolio

The market portfolio represents the entire market of risky securities. The weight on each security is therefore its market weight, given by the ratio of the market capitalization of the security divided by the total market capitalization. This is an example of a value weighted portfolio.
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Capital Asset Pricing Model

William Sharp
1990 Nobel Prize in Economics for his contributions to the theory of price formation for financial assets, the so-called, Capital Asset Pricing Model (CAPM)
Interview with Sharp and Markowitz http://www.afajof.org/association/historyfinance.asp

Capital Asset Pricing Model

E ( ri )= r f + Cov ( r i , r m )

2 m

E ( rm ) - r f

i=

Cov( r i , r m ) i, m = 2 Var( r m ) m

= r f + i

E ( rm ) - r f

Expected Returns Depends on Beta

The expected return on an asset is determined by the beta of asset, which also measures the covariance between the return on the asset and the return on the market portfolio. Cov ( r i , r m ) E ( rm ) - r f E ( ri )= r f + 2 m

Excess Returns and Beta

The expected excess return of a security is proportional to the expected excess return of the market. The proportionality factor is beta.

It is the covariance of an asset with the market that determines the excess returns!
Assets with a negative beta reduces the overall risk of the portfolio and investors are willing to accept a rate of return that is lower than the risk-free rate of return.
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Betas are Linear

Betas are linear Beta(aA+bB) = a *Beta(A)+b*(Beta(B) because cov(aA +bB,M) = a*cov(A,M)+b*cov(B,M)

p = wi i
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Security Market Line

E(ri )
Security market Line

E(rm )

E(ri ) r f i (rM - r f )

rf
0 1.0

m = 1 (market) r = 0 (risk free)

f

Beta
10

Example
Stock A B C D E Beta 0.70 1.00 1.15 1.40 -0.30

Rf = 5% (0.05) RM = 9% (0.09) Implied market risk premium = 4% (0.04)

Assume:

E ( ri ) r f i

E ( rm ) - r f

E(RA) = 0.05 + 0.70 (0.09-0.05) = 0.078 = 7.8% E(RB) = 0.05 + 1.00 (0.09-0.05) = 0.090 = 09.0%

E(RC) = 0.05 + 1.15 (0.09-0.05) = 0.096 = 09.6%

E(RD) = 0.05 + 1.40 (0.09-0.05) = 0.106 = 10.6% E(RE) = 0.05 + -0.30 (0.09-0.05) = 0.038 = 03.8%
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All Efficient Securities Lie on the SML

E(ri )
E(rm )

Security Market Line

E(ri ) rf

(rM - rf )

Negative Beta

rf

1.0

Beta
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When Not in Equilibrium

E(ri )
E(rm )

Return Lies Above the SML

Stock is Undervalued

rf

Return Lies Below the SML

Stock is Overvalued

1.0

Beta
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Teachers notes
Difference between beta and standard deviation. Know difference between CAL,SML,CML Equilbirium model where demand =supply. That is like what the diagram describes. Every asset you can think of, has a certain demand and supply, if markets are efficient, then clear at a price. Then expected returns and prices are related. For every asset, given you started, if price goes up, the more you pay for the return, the lower you get. Price and returns are inversely related-equilibrium price. If down below 0, price too high.
14 Albert Lee Chun Portfolio Management