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Chapter 18 CAPITAL ASSET PRICING THEORY

What is the capital market line (CML)?

How is the Capital Asset Pricing Model (CAPM) developed?


What is the difference between the standard deviation risk and beta risk measures? How can an investor apply the CAPM to security analysis? How do you estimate beta? What are the good news and the bad news about beta? Contemporary Investments: Chapter 18

Assumptions of the Capital Asset Pricing Model


Investors have homogeneous expectations
Frictionless capital markets

Investors are rational and seek to maximize their expected utility functions
Investment is for one-period only

All investors can borrow or lend at the riskfree rate


Contemporary Investments: Chapter 18

Efficient frontier and the optimal risky portfolio


Developing the capital market line (CML)
Introducing the riskfree asset. The capital market line (CML) or the borrowing-lending line. The Portfolio Separation Theorem The market portfolio, M
Contemporary Investments: Chapter 18

Figure 18.1 Efficient Frontier

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Figure 18.2 Efficient Frontier and Utility Curves for Investors A and B

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Figure 18.3 Combinations of the Risk-Free Asset RF and Risky Portfolios P1 and P2

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Figure 18.4 Combinations of the Risk-Free Asset RF and the Risky Portfolio M

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Figure 18.5 CML and Individual Utility Curves

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Figure 18.6 CML: The Borrowing-Lending Line

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Capital Asset Pricing Model


Developing a relative risk measure
Understanding beta
Systematic risk or market risk Diversifiable risk or firm-specific risk

Contemporary Investments: Chapter 18

Figure 18.7 CML and Individual Securities

Contemporary Investments: Chapter 18

CAPM derivation
Security risk and return
Reward for investing in a security Security risk Securitys reward-to-risk ratio Risk/return relationship The security market line (SML)

Differences between the CML and SML


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Figure 18.8 Security Market Line (SML)

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CAPM and security analysis


Estimating the required return.
Estimating the predicted return.

Security analysis decision rule.


Comparison with fundamental analysis.

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Estimating Beta
Security characteristic line
Information service beta estimates

Calculating beta: Separating systematic risk from diversifiable risk. Differences between the SML and the security characteristic line
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Good news and bad news about Beta


How reliable are beta estimates?
Does beta really measure risk?

The verdict on beta.

Implications for investors


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Figure 18.9 Security Market Line Analysis

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Figure 18.10 Regression Analysis to Estimate Beta

Contemporary Investments: Chapter 18