Capital Asset Pricing Model

Dr. Himanshu Joshi

Capital Asset Pricing Model

The Capital Asset Pricing Model is set of predictions concerning equilibrium expected returns on risky assets. Harry Markowitz laid down the foundation of modern portfolio management in 1952. The CAPM was developed 12 years later in articles by William Sharpe, John Lintner, and Jan Mossin.

William Sharpe, Capital Asset Prices: A Theory of Market Equilibrium, Journal of Finance, September 1964. John Linter, The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets, Review of Economics and Statistics, February 1965. Jan Mossin, Equilibrium in a Capital Asset Market, Econometrica, October 1966.

Basic Version of CAPM Assumptions

1. There are many investors, each with an endowment (wealth) that is small compared to the total endowment for all investors. (Investors are price takers, in that security prices are unaffected by their own trade.) 2. All investors plan for one identical holding period. This behavior is short sighted in that it ignores every thing that might happen after the end of the single period horizon. This myopic behavior in general sub optimal.

Basic Version of CAPM Assumptions

3. Investments are limited to a universe of publicly traded financial assets, such as stocks and bonds, and risk free borrowings or lending arrangements. 4. Investors pay no taxes on returns and no transaction costs (commission and service charges) on trades in securities. 5. All investors are rational mean-variance optimizers, meaning that they all use the Markowitz Portfolio Selection Model.

Basic Version of CAPM Assumptions

6. All investors analyze securities in the same way and share the same economic view of the world. The result is identical estimates of the probability distribution of future cash flows from investing in the available securities. Given a set of security prices and risk free interest rate, all investors use the same expected returns and covariance matrix of security returns to generate the efficient frontier and unique optimal risky portfolio. This assumption is known as Homogeneous Expectations.

Market Equilibrium..
We can summarize the equilibrium that will prevail in this hypothetical world of securities and investors. 1. All investors will choose to hold a portfolio of risky assets in proportions that duplicate representation of the assets in the market portfolio (M), which include all traded assets. The proportion of each stock in the market portfolio (M) equals the market value of the stock (price per share * number of shares outstanding) divided by the total market value of all stocks. (MPS* No. of Shares Outstanding)/Total Market Value of All Shares in the Market.

Market Equilibrium..
2. Not only will the market portfolio be on the efficient frontier, but it also will be the tangency portfolio to the optimal capital allocation line (CAL) derived by each and every investor. As a result, the Capital Market Line (CML), the line from risk free rate through the market portfolio, M, is also the best attainable capital allocation line. All investors hold M as their optimal risky portfolio, differing only in the amount invested in it versus in the risk free asset.

Market Equilibrium..
Utility Score of an individual: U = E(r) A 2 Where E(r) = expected return A = index of the investors risk aversion. Consider three investors with different degree of risk aversion: A1 = 2, A2 = 3.5, A3 = 5. All of them are evaluating three portfolios:
Portfolio
L M H

Risk Premium Expected Return

2% 4 8 7% 9 13

SD
5% 10 20

Capital Market Line

Return(%)
B

Rf

Risk: Portfolio Standard Deviation

Market Equilibrium..
CAPM is an outgrowth of the Markowitz model and extends the concept of optimal diversified portfolios to the market in general and to the valuation of individual securities. That is, the concept is applied in both a macro context that specifies relation between risk and return on a portfolio. (CML) And Micro context that specifies the relationship between risk and the return on a specific asset. (SML)

Capital Market Line

The equation of the line: Y = a + b X, In which Y = return on the portfolio (rp); a is the intercept (rf); X measures risk and b is the slope of line. Thus equation of Capital Market Line can be written as: rp= rf + (rm-rf)* p/m

Capital Market Line

This equation states that the return on a portfolio (rp) is the sum of the return earned on a risk free asset (rf) and risk premium that depends upon: (1) the extent to which the return on the market exceeds the risk free return (rm-rf), (2) the dispersion of the portfolio (p) relative to the dispersion of the market (m).

Capital Market Line

If the dispersion of the portfolio is equal to the dispersion of the market, these two considerations cancel; the return on such a portfolio depends solely on the risk free rate and the risk premium associated with investing in securities.

Capital Market Line

CML by itself does not determine which portfolio the individual investor will acquire. The actual portfolio the individual selects depends on the capital market line and individuals willingness to bear risk, as indicated by the indifference curves.

Practical Capital Market Line

Return(%)

Options, and Future Contracts

Small Corporation's Stocks Large Corporations Stock Long term Debt

Rf

T-Bills

Risk: Portfolio Standard Deviation

An Investors Trade-off Between Risk and Return with a Risk Free Asset.
Large Cap Stocks Expected Return Variance Standard Deviation 15% 225 15% Government Bonds Risk Free Asset 5% 100 10% 4% 0 0%

Correlations: Large Cap Stock and Government bonds =0.5 Large Cap Stock and Risk free asset = 0 Government Bonds and risk free asset = 0 Weights: 1. Entire portfolio in the risk free asset. 2. Entire portfolio in large cap stock. 3. Change in weights. 4. Entire portfolio into government bond. 5. Change in weights 6. Change in weights between large cap and government bonds

The Capital Asset Pricing Model and Beta Coefficients

The Second component of the CAPM is the specification of the relationship between risk and return for individual assets. (SML) In CML, the risk is measured by the portfolios standard deviation. In SML the risk is measured by a Beta Coefficient.

The Capital Asset Pricing Model and Beta Coefficients

Beta = S.D of the Return on Stock i * im S.D of the Return on the Market i = i / m * im im = Correlation Coefficient between the Return on the stock and return on the market.

The Capital Asset Pricing Model and Beta Coefficients

Thus Beta depends upon: 1. the variability of the individual stocks return 2. the variability of the market return 3. the correlation between return on the security and the return on the market.

The Capital Asset Pricing Model and Beta Coefficients

The Ratio of SDs measures how variable the stock is relative to the variability of the market. The Correlation Coefficient indicates whether this greater variability is important.

The Capital Asset Pricing Model and Beta Coefficients

SD of the MArket Correlation Coeff. SD of the Stock 2% 6% 10% 14% 10% 1 Beta .2 .6 1.0 1.4

The Capital Asset Pricing Model and Beta Coefficients

SD of the Market SD of the Stock Correlation Coeff. -1 -.5 0 1.0 10% 10% Beta -1.0 -0.5 0 1.0

As Long as there is a strong relationship between the return on the stock and the return On the market (the Correlation Coeff. Is not a small number), the Beta Coefficient has meaning.

Security Market Line

Return(%) SML

Rs = Rf + (Rm Rf) *

Rf Risk:

Security Market Line

Rs = Rf + (Rm Rf) *

Derivation of SML
Consider any portfolio, denoted by p, that consist of the proportion Xi invested in Security i and the proportion (1-Xi) in market portfolio M. For this portfolio: Expected Return rp= Xi*ri + (1-Xi)*rm p = [Xi2i2 + (1-Xi)2m2 + 2*Xi*(1-Xi)*im]1/2

Extended Version of the CAPM

Imposing Restrictions on Risk Free Borrowing and Lending: The original CAPM assumes that investors can lend or borrow at the same risk free rate of interest. In reality such borrowing is likely to be either unavailable or restricted in amount. So, investor can lend money recklessly @ rfl. Investor can borrow money without limit @ rfb.

Extended Version of the CAPM

Liquidity Preference and Beta Ri = Rf + (Rm-Rf) + LX + e

Arbitrage Pricing Theory

In Arbitrage, the securitys price movement and return are not explained by a relationship between risk and return. Security returns are the result of arbitrage as investors seek to take advantage of perceived differences in prices and risk exposure.

APT Assumption..
Each investor, when given the opportunity to increase the return of his portfolio without increasing risk, will proceed to do so. The mechanism of doing so involves the use of arbitrage portfolios.

Arbitrage Pricing Theory

Systematic Influences: A Systematic influence may be interest rates or the level of economic activity. For Example: High Dividend Paying stocks may more readily respond to changes in interest rates, while cyclical stocks may more readily respond to changes in the level of economic activity. Even though two stocks have the same beta coeff. and have responded in a similar fashion to a change in the market, they may respond differently to changes in other factors. For this reason, a portfolio stressing fixed income securities may experience a larger response to a change in inflation than a portfolio stressing economic growth.

Arbitrage Portfolios
Imagine that an investor owns three stocks, and the current market value of his holdings in each one is $40,00,000. in this case the investors current investable wealth W0 is equal to $1,20,00,000. Everyone believe that these three securities have the following expected returns.
I Stock 1 Ri 15% bi .9

2 3

21 12

3.0 1.8

Arbitrage Portfolios
According to APT, an investor will explore the possibility of forming an arbitrage portfolio in order to increase the expected return of his or her current portfolio without increasing its risk. What is an arbitrage portfolio? (1) it is a portfolio that does not require any additional funds from the investor. If Xi denotes the change in the investors holdings of security i (and hence the weight of security I in arbitrage portfolio) then this requirement can be written as: X1+X2+X3 = 0

Arbitrage Portfolios
(2) an arbitrage portfolio has no sensitivity to any factor. (zero factor exposure). Because sensitivity of a portfolio is just a weighted average of sensitivities of the securities in the portfolio to that factor. This requirement of an arbitrage portfolio for one factor model can be written as: b1X1+b2X2+b3X3 = 0 Or, in our example: .9X1+3X2+1.8X3 = 0

Arbitrage Portfolios
At this point many potential arbitrage portfolios can be identified. These portfolios are simply portfolios that meet the requirement equation (1) and (2). Suppose X1 = .1 .1+X2+X3 = 0 .09+3.0X2+1.8X3 = 0 X2= .075 and X3 = -.175.

Arbitrage Portfolios
To see if this candidate portfolio is indeed an arbitrage portfolio, one must determine its expected return. If expected return is positive, then an AP has been identified. X1r1+X2r2+X3r3 >0 15X1+21X2+12X3 >0

APT Limitations..
Measurement of unanticipated changes in factors. APT is in developing process.