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CHAPTER 9

The Capital Asset


Pricing Model

Investments, 8th edition


Bodie, Kane and Marcus
Slides by Susan Hine
McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All

Capital Asset Pricing Model (CAPM)


It is the equilibrium model that underlies all
modern financial theory
Derived using principles of diversification with
simplified assumptions
Markowitz, Sharpe, Lintner and Mossin are
researchers credited with its development

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Assumptions
Individual investors are price takers
Single-period investment horizon
Investments are limited to traded financial
assets
No taxes and transaction costs

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Assumptions Continued
Information is costless and available to all
investors
Investors are rational mean-variance
optimizers
There are homogeneous expectations

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Resulting Equilibrium Conditions


All investors will hold the same portfolio for
risky assets market portfolio
Market portfolio contains all securities and
the proportion of each security is its market
value as a percentage of total market value

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Resulting Equilibrium Conditions


Continued
Risk premium on the market depends on the
average risk aversion of all market
participants
Risk premium on an individual security is a
function of its covariance with the market

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Figure 9.1 The Efficient Frontier and the


Capital Market Line

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Market Risk Premium


The risk premium on the market portfolio will
be proportional to its risk and the degree of risk
aversion of the investor:
E (rM ) rf A M2
where M2 is the variance of the market portolio and
A is the average degree of risk aversion across investors

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Return and Risk For Individual Securities


The risk premium on individual securities is a
function of the individual securitys
contribution to the risk of the market portfolio
An individual securitys risk premium is a
function of the covariance of returns with the
assets that make up the market portfolio

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Using GE Text Example


Covariance of GE return with the market
portfolio:

Cov(rGE , rM ) Cov rGE , wk rk wk Cov (rk , rGE )


k 1
k 1

Therefore, the reward-to-risk ratio for


investments in GE would be:
E (rGE ) rf
GE's contribution to risk premium wGE E (rGE ) rf

GE's contribution to variance


wGE Cov( rGE , rM ) Cov( rGE , rM )

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Using GE Text Example Continued


Reward-to-risk ratio for investment in
market portfolio:
Market risk premium E (rM ) rf

Market variance
M2

Reward-to-risk ratios of GE and the market


portfolio:
E (rGE ) rf
E (rM (rf )
Cov(rGE , rM )

M2

And the risk premium for GE:


Cov(rGE , rM )
E (rM ) rf
E (rGE ) rf
2
M
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Expected Return-Beta Relationship


CAPM holds for the overall portfolio because:

E (rP ) wk E (rk ) and


k

P wk k
k

This also holds for the market portfolio:

E (rM ) rf M E (rM ) rf
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Figure 9.2 The Security Market Line

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Figure 9.3 The SML and a Positive-Alpha


Stock

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The Index Model and Realized Returns


To move from expected to realized returns
use the index model in excess return form:

Ri i i RM ei
The index model beta coefficient turns out to
be the same beta as that of the CAPM
expected return-beta relationship

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Figure 9.4 Estimates of Individual Mutual


Fund Alphas, 1972-1991

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The CAPM and Reality


Is the condition of zero alphas for all stocks
as implied by the CAPM met
Not perfect but one of the best available
Is the CAPM testable
Proxies must be used for the market
portfolio
CAPM is still considered the best available
description of security pricing and is widely
accepted
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Econometrics and the Expected ReturnBeta Relationship


It is important to consider the econometric
technique used for the model estimated
Statistical bias is easily introduced
Miller and Scholes paper demonstrated
how econometric problems could lead one
to reject the CAPM even if it were perfectly
valid

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Extensions of the CAPM


Zero-Beta Model
Helps to explain positive alphas on low beta
stocks and negative alphas on high beta
stocks
Consideration of labor income and non-traded
assets
Mertons Multiperiod Model and hedge portfolios
Incorporation of the effects of changes in the
real rate of interest and inflation

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Extensions of the CAPM Continued


A consumption-based CAPM
Models by Rubinstein, Lucas, and Breeden
Investor must allocate current wealth between
todays consumption and investment for the future

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Liquidity and the CAPM


Liquidity
Illiquidity Premium
Research supports a premium for illiquidity.
Amihud and Mendelson
Acharya and Pedersen

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Figure 9.5 The Relationship Between


Illiquidity and Average Returns

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Three Elements of Liquidity


Sensitivity of securitys illiquidity to market
illiquidity: L1 Cov(Ci , CM )
Var ( RM CM )

Sensitivity of stocks return to market


illiquidity: Cov( R , C )
L2

Var ( RM CM )

Sensitivity of the security illiquidity to the


market rate of return:
L3

Cov(Ci , RM )

Var ( RM CM )

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