Anda di halaman 1dari 31

Capital Asset Pricing Model (CAPM)


William Sharpe (1964), John Linter (1965)
Widely used to estimate the Cost of Capital and
evaluating portfolio performance
Offers predictions about how to measure risk and
relation between expected return & risk
Empirical record of model is poor and most
applications of the model are invalid
The Logic of CAPM

Builds on model of portfolio choice developed by
Markowitz (1959)
Investor selects a portfolio at time t-1 that produce
stochastic (random) return at t
The model assumes investors as risk averse and
choose mean-variance efficient portfolios
Minimize variance of portfolio at a given expected
return, and maximize expected return at given
variance (Mean-Variance Model)

Assumptions of Mean-variance risk portfolio
Complete Agreement: Given market clearing prices
at t-1, investors agree on joint distribution of assets
returns from t to t-1
Borrowing or lending at Risk Free rate is
independent of how much amount borrowed on lent

Investment Opportunities
ABC Curve = Minimum variance curve (Tells
combinations of E(R) and Risk for risky assets
portfolio that minimize variance at different levels of
Expected Return. Points above b are mean-
variance efficient
Investment Opportunities
Adding the Risk Free rate turns efficient portfolio
into a straight line.
Consider an investor who invests x portion of
investment in a Risk Free Security and 1-x portion
of investment in risky assets (g).
Combinations of investment in Risk Free Securities
and in g securities is a straight line between Rf
and g.
Points to the right of g represents borrowing at g
with the proceeds of borrowing used to increase
investment in portfolio g.
Line from Rf to g represents lending at Rf rate with
risky assets borrowing at point g

Punch-Line for CAPM
Since investors have complete agreement about
distribution returns, they combine same risky
tangency portfolio T with risk-free lending or
T must be the value-weight market portfolio of risky
assets or each risky assets weight in tangency
portfolio (M i.e. Market)
M is the total market value of all outstanding units of
assets divided by total market value of all risky
CAPM assumptions imply that market portfolio M
must be on minimum variance frontier if assets is to
clear market.
If there are N number of assets then:
Sensitivity of a security with respect to market i.e.
how fast a security tends to move/align itself with
the change in market.
It is a systematic risk
Bi,m is the covariance risk of asset i in M measured
relative to the average covariance risk of assets.)
When a risky assets return is uncorrelated with the
market return, its beta is zero [E(Rzm)].
This type of risky asset is riskless in the market
portfolio as it contributes nothing to the variance of
the market return.
When there is risk free borrowing or lending, the
expected return of assets that are uncorrelated with
the market [E(Rzm)] must be equal to Rf rate.
Hence, the relation between expected return and
beta then becomes:
The Expected return on any asset is the risk free
interest rate Rf, plus a risk premium which is
assets market beta B i,m, times premium per unit
beta risk, E(Rm)-Rf
Early Empirical Tests
Based on three assumptions

i) Expected returns on all assets are linearly related
their betas, and no other variable has marginal
explanatory power.
ii) Beta premium is positive, meaning that the
return on the market portfolio exceeds the
return on assets whose returns are uncorrelated
the market return.
iii) Assets uncorrelated with the market have
returns equal to the risk-free interest rate, and the
beta premium is the expected market return
the risk-free rate.

The Black, Jensen, and Scholes test (1972)
If market portfolio is efficient, it follows automatically
that a linear, positively sloped relationship exists
between betas and expected rates of return.
If investors can borrow and lend at a risk-free rate,
it also follows that a zero beta stock or portfolio can
be expected to produce a return equal to the risk-
free rate.
The empirical test of BLACK, JENSEN, AND
SCHOLES (BJS) is designed to test these
properties of the security market line.
Hypothesis: Average returns (in a cross section of
stocks) depend linearly (and solely) on asset betas
Individual stock returns are so volatile therefore
Portfolios are being used to test hypothesis

The Black, Jensen, and Scholes test (1972)
They calculated beta for all portfolios during the
sub-period (Market index = an equally weighted
portfolio of all stocks on the NYSE).
They estimate the beta of each portfolio by relating
the portfolio returns to their market index.
The relationship they find between beta and
average rate of return is depicted in the following
The Black, Jensen, and Scholes test (1972)
BJS concluded that their results are
consistent with the form of the CAPM that
allows for riskless lending but doesnt allow
riskless borrowing.

The Fama-Macbeth (FM)study (1974)
Like BJS, the finding of FM is again
consistent with the form of the CAPM where
lending at the risk-free rate is permitted but
borrowing is precluded.
On average, positive trade off between risk
and return
Different studies with their findings
Studies Findings
Black, Jensen, and
Scholes (1972)
Fama and MacBeth
Reinganum (1981)
Lakonishok and
Shapiro (1986)
Fama and French

Positive relation between average return and market
beta (1926-1968).

The relation between and average return disappears
during the more recent period (1963-1990)
Different studies with their findings
Studies Findings
Banz (1981)

Bhandari (1988)

Basu (1983)

A strong negative relation between average return and
firm size. When stocks are sorted on market
capitalization, average returns on small stocks are
higher than predicted by the CAPM.

Average return is positively related to leverage. Returns
on highly geared firms are too high relative to their
market betas.

A positive relation between average return and E/P.
When common stocks are sorted on earnings-price
ratios, future returns on high E/P stocks are higher than
predicted by the CAPM.

Different studies with their findings
Studies Findings

Stattman (1980)
Rosenberg, Reid,
and Lanstein (1985)

Chan, Hamao, and
Lakonishok (1992)

A positive relationship between average return and
book-to-market equity for US stocks.
Stocks with high book-to-market equity ratios have high
average returns that are not captured by their betas.

BE/ME is a powerful variable for explaining average
returns on Japanese stocks.

ICAPM extension of the Capital Asset Pricing Model
(Metron, 1973)
In the CAPM, investors care only about the wealth
portfolio produces at the end of the current period.
In the ICAPM, investors are concerned not only with
their end-of-period payoff, but also with the
opportunities they will have to consume or invest the
Thus, when choosing a portfolio at time t -1, ICAPM
investors consider how their wealth at t might vary
with future state variables, including labor income,
the prices of consumption goods and the nature of
portfolio opportunities at t, and expectations about
the labor income, consumption and investment
opportunities to be available after t.
As a result, optimal portfolios are multifactor
efficient, which means they have the largest possible
expected returns, given their return variances and the
co-variances of their returns with the relevant state
Fama and French (1992)
Their bottom line results are
(a) Beta does not seem to help explain the
cross-section of average stock returns
(b) The combination of size and book-to-
market equity seems to absorb the roles of
leverage and E/P in average stock returns,
at least during their 1963-1990 sample
Fama and French
"Beta," the measure of market exposure of a
given stock or portfolio, which was previously
thought to be the measurement of stock
risk/return, is of only limited use. It did not
explain the returns of all equity portfolios,
although it is still useful in explaining the return
of stock/bond and stock/cash mixes.
Fama and French (1992) confirm the evidence
that the relation between average return and
beta for common stocks is even flatter after the
sample periods used in the early empirical
works on the CAPM.
If betas do not suffice to explain expected
returns, the market portfolio is not efficient, and
the CAPM is dead in its tracks.
The Fama-French Three-Factor Model

Return is explained by three factors:
Market factor (market index)
Size factor (market capitalization)
Book- to-market ratio (Book Equity/Market

The Fama-French Three-Factor Model
The additional factors are empirically
motivated by the observations that
historical-average returns on stocks of
small firms and on stocks with high
ratios of book equity to market equity
(B/) are higher than predicted by the
security market line of the CAPM.

The Fama-French Three-Factor Model
To create portfolios that track the firm size
and book-to-market factors, Davis, Fama,
and French (2000) sorted firms annually by
size (market capitalization) and by book-to-
market (B/M) ratio.
The small-firm group (S) :all firms with 33%
lowest market capitalization.
Medium firm group (M) :all firm with next
Big-firm group (B):all firm with 33% highest
market capitalization
The Fama-French Three-Factor Model
Similarly, firms are annually sorted into
groups based on (B/M) ratio.
A low-ratio group (L) with 33% lowest B/M
A medium-ratio group (M) with next 34%
A high ratio group (H) with 33% highest B/M
A high ratio firm is called value firm and the
low ratio firm is called growth firm.
The Fama-French Three-Factor Model
For each year, the size premium (SMB) is
constructed as the difference in returns
between small and large firms.
Similarly, the book-to-market effect is
calculated from the difference in returns
between high B/M ratio and low B/M ratio firms.
The monthly returns on the market portfolio
were calculated from the value-weighted
portfolio of all firms listed on the NYSE, AMEX,
The risk-free rate was the return on 1-month

Interpretation of the results
The findings:
Small firms have higher average returns
than large firm.
Firms with high ratios of book value to
market value of common equity have higher
average returns than firms with low book-to-
market ratios.
Since the CAPM does not explain this
pattern in average returns, it is typically
called anomaly.
How should we interpret these results?
One argument is that size and relative
value (as measured by the B/M ratio) proxy
for risk is not captured by the CAPM beta
Another explanation attributes these
premium to irrational investors preferences
for large size or low B/M firms (growth
firms). This evidence may be more relevant
for the B/M or value factor in light of the
evidence that size premium has largely
vanished in recent years.
The irrational investor preference for value
premium explanation says it is due to
investor overreaction to firm performance.
High BE/ME stocks tend to be firms that are
weak on fundamentals like earnings and
sales, while low BE/ME stocks tend to have
strong fundamentals. Investors overreact to
performance and assign irrationally low
values to weak firms and irrationally high
values to strong firms. When the
overreaction is corrected, weak firms have
high stock returns and strong firms have
low returns.
Three-Factor Model: Evaluating Fund Managers
This model can also used to measure historical fund
manager performance to determine the amount of
value added by management.
Where , I is the Y-intercept of the equation, is the
Active Return and defined as:
= Active Return = (Portfolio Actual Return -
Benchmark Actual Return)
Historical data is utilized in a multiple regression
analysis to determine the value of
Alpha indicates how well the fund manager is
capturing the expected returns, given the portfolio's
exposure to the
If the fund manager captures the factor exposures
perfectly, the expected alpha would be zero, minus
the expense ratio (ER) of the fund.
Three-Factor Model: Evaluating Fund Managers
Alpha greater than this suggests that the fund
manager is adding value beyond the underlying
factor exposures.

From a theoretical perspective, the main shortcoming
of the three-factor model is its empirical motivation.
The small-minus-big (SMB) and high-minus-low
(HML) explanatory returns are not motivated by
predictions about state variables of concern to
investors. Instead they are brute force constructs
meant to capture the patterns uncovered by previous
work on how average stock returns vary with size and
the book-to-market equity ratio.
Three-Factor Model
Market Proxy Problem
Richard Roll (1977) thinks that the CAPM and the
market portfolio are untestable without accurate
specification of the true market portfolio. Roll
(1978) strengthens his argument by showing that
different indexes used as proxies for the market
portfolio can cause different portfolio-performance
It is not theoretically clear which assets (for
example, human capital) can legitimately be
excluded from the market portfolio, and data
availability substantially limits the assets that are
included. As a result, tests of the CAPM are forced
to use proxies for the market portfolio.
Market Proxy Problem
Since the relation between expected return
and market beta of the CAPM is just the
minimum variance condition that holds in
any efficient portfolio, applied to the market
portfolio. Thus, if we can find a market
proxy that is on the minimum variance
frontier, it can be used to describe
differences in expected returns.
It is always possible that researchers will
redeem the CAPM by finding a reasonable
proxy for the market portfolio that is on the
minimum variance frontier.
Summary: Three-Factor Model
"Beta," the measure of market exposure of a given
stock or portfolio, which was previously thought to be
the measurement of stock risk/return, is of only
limited use. It did not explain the returns of all equity
portfolios, although it is still useful in explaining the
return of stock/bond and stock/cash mixes.
The return of any stock portfolio can be explained
almost entirely (around 95%) by including two
additional factors: Market cap ("Size") and
book/market ratio ("Value").
Therefore, a portfolio with a small median market cap
and a high book/market ratio will have a higher
Expected return than a portfolio with a large median
market cap and a low book/market ratio