Models for the Pricing of

Assets

Chapter 9
Charles P. Jones, Investments: Analysis and
Management,
Tenth Edition, John Wiley & Sons

Prepared by
G.D. Koppenhaver, Iowa State University

9-1
Capital Asset Pricing Model

Focus on the equilibrium relationship

between the risk and expected return
on risky assets
Builds on Markowitz portfolio theory
Each investor is assumed to diversify
his or her portfolio according to the
Markowitz model

9-2
CAPM Assumptions
All investors: No transaction costs,
Use the same no personal income
information to taxes, no inflation
generate an efficient
frontier
No single investor
Have the same one-
can affect the price
period time horizon of a stock
Can borrow or lend Capital markets are
money at the risk-free in equilibrium
rate of return

9-3
Borrowing and Lending Possibilities

Risk free assets

Certain-to-be-earned expected return and a
variance of return of zero
No correlation with risky assets
Usually proxied by a Treasury security
Amount to be received at maturity is free of
default risk, known with certainty
Adding a risk-free asset extends and
changes the efficient frontier

9-4
Risk-Free Lending
Riskless assets can
L be combined with
any portfolio in the
B
efficient set AB
E(R) T Z implies lending
Z X Set of portfolios on
RF line RF to T
A dominates all
portfolios below it

Risk
9-5
Impact of Risk-Free Lending

If wRF placed in a risk-free asset

Expected portfolio return
E(R p ) w RF RF ( 1-w RF )E(R X )
Risk of the portfolio
p ( 1-w RF ) X
Expected return and risk of the
portfolio with lending is a weighted
average

9-6
Borrowing Possibilities

Investor no longer restricted to own

wealth
Interest paid on borrowed money
Higher returns sought to cover expense
Assume borrowing at RF
Risk will increase as the amount of
borrowing increases
Financial leverage

9-7
The New Efficient Set

Risk-free investing and borrowing

creates a new set of expected return-
risk possibilities
Addition of risk-free asset results in
A change in the efficient set from an arc to
a straight line tangent to the feasible set
without the riskless asset
Chosen portfolio depends on investors risk-
return preferences

9-8
Portfolio Choice

The more conservative the investor the

more is placed in risk-free lending and
the less borrowing
The more aggressive the investor the
less is placed in risk-free lending and
the more borrowing
Most aggressive investors would use
leverage to invest more in portfolio T

9-9
Market Portfolio

Most important implication of the CAPM

All investors hold the same optimal portfolio
of risky assets
The optimal portfolio is at the highest point
of tangency between RF and the efficient
frontier
The portfolio of all risky assets is the
optimal risky portfolio
Called the market portfolio

9-10
Characteristics of the Market
Portfolio
All risky assets must be in portfolio, so
it is completely diversified
Includes only systematic risk
All securities included in proportion to
their market value
Unobservable but proxied by S&P 500
Contains worldwide assets
Financial and real assets

9-11
Capital Market Line

Line from RF to L is
L
capital market line
M (CML)
E(RM) x = risk premium
=E(RM) - RF
x
y =risk =M
RF Slope =x/y
y
=[E(RM) - RF]/M
M
y-intercept = RF
Risk
9-12
The Separation Theorem
Investors use their preferences
(reflected in an indifference curve) to
determine their optimal portfolio
Separation Theorem:
The investment decision, which risky
portfolio to hold, is separate from the
financing decision
Allocation between risk-free asset and risky
portfolio separate from choice of risky
portfolio, T

9-13
Separation Theorem

All investors
Invest in the same portfolio
Attain any point on the straight line RF-T-L
by by either borrowing or lending at the
rate RF, depending on their preferences
Risky portfolios are not tailored to each
individuals taste

9-14
Capital Market Line

Slope of the CML is the market price of

risk for efficient portfolios, or the
equilibrium price of risk in the market
Relationship between risk and expected
return for portfolio P (Equation for
CML):
E(RM ) RF
E(R p ) RF p
M

9-15
Security Market Line

CML Equation only applies to markets

in equilibrium and efficient portfolios
The Security Market Line depicts the
tradeoff between risk and expected
return for individual securities
Under CAPM, all investors hold the
market portfolio
How does an individual security contribute
to the risk of the market portfolio?

9-16
Security Market Line

A securitys contribution to the risk of

the market portfolio is based on beta
Equation for expected return for an
individual stock

E(Ri ) RF i E(RM ) RF

9-17
Security Market Line

SM Beta = 1.0 implies

E(R) L as risky as market
A
Securities A and B
kM B are more risky than
C the market
kRF Beta >1.0
Security C is less

risky than the

0 0.5 1.0 1.5 2.0 market
BetaM
Beta <1.0

9-18
Security Market Line

Beta measures systematic risk

Measures relative risk compared to the
market portfolio of all stocks
Volatility different than market
All securities should lie on the SML
The expected return on the security should
be only that return needed to compensate
for systematic risk

9-19
CAPMs Expected
Return-Beta Relationship
Required rate of return on an asset (ki)
is composed of
risk-free rate (RF)
risk premium (i [ E(RM) - RF ])
Market risk premium adjusted for specific security
ki = RF +i [ E(RM) - RF ]
The greater the systematic risk, the greater
the required return

9-20
Estimating the SML

Treasury Bill rate used to estimate RF

Expected market return unobservable
Estimated using past market returns and
taking an expected value
Estimating individual security betas
difficult
Only company-specific factor in CAPM
Requires asset-specific forecast

9-21
Estimating Beta

Market model
Relates the return on each stock to the
return on the market, assuming a linear
relationship
Ri = i + i RM +ei
Characteristic line
Line fit to total returns for a security
relative to total returns for the market
index

9-22
How Accurate Are Beta
Estimates?
Betas change with a companys
situation
Not stationary over time
Estimating a future beta
May differ from the historical beta
RM represents the total of all
marketable assets in the economy
Approximated with a stock market index
Approximates return on all common stocks

9-23
How Accurate Are Beta
Estimates?
No one correct number of observations
and time periods for calculating beta
The regression calculations of the true
and from the characteristic line are
subject to estimation error
Portfolio betas more reliable than
individual security betas

9-24
Arbitrage Pricing Theory

Based on the Law of One Price

Two otherwise identical assets cannot sell at
different prices
Equilibrium prices adjust to eliminate all
arbitrage opportunities
Unlike CAPM, APT does not assume
single-period investment horizon, absence
of personal taxes, riskless borrowing or
lending, mean-variance decisions

9-25
Factors

APT assumes returns generated by a

factor model
Factor Characteristics
Each risk must have a pervasive influence
on stock returns
Risk factors must influence expected return
and have nonzero prices
Risk factors must be unpredictable to the
market

9-26
APT Model

Most important are the deviations of

the factors from their expected values
The expected return-risk relationship
for the APT can be described as:
E(Ri) =RF +bi1 (risk premium for
factor 1) +bi2 (risk premium for
factor 2) + +bin (risk premium
for factor n)

9-27
Problems with APT

Factors are not well specified ex ante

To implement the APT model, need the
factors that account for the differences
among security returns
CAPM identifies market portfolio as single factor
Neither CAPM or APT has been proven
superior
Both rely on unobservable expectations

9-28
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9-29