Joint Degree Programme Corporate Finance module

Lesson 3 - Supplemental Reading

CAPM derivation (not obligatory for the test)

Assumptions

Let's have a stock traded on efficient market

Where investors are myopic (CAPM is static model)
Investors have rational expectations and are risk-averse
Returns have joint (normal) distribution
Investors are mean/variance maximizers (so they maximize ratio of expected return E (rP )
on their portfolio P to its variance P2

Unlimited deposits and borrowing for constant riskfree rates r f

As the investors are risk averse, we can describe their utility functions as convex and strictly
growing in risk
U1
r
U2
U3

The portfolio creation process consists of 3 phases:

1) finding the efficient portfolio frontier

2) finding a point on the efficient portfolio frontier, which touches capital market line CML
3) combining the best portfolio M with riskfree asset r f so that the combination is a point
where capital market line CML touches the highest indifference curve.

U1

CML

P*

rf

2008 Ing. Tom Buus, Ph.D.

CML is the set of the best attainable portfolios combined of market portfolio M and riskfree asset
r f . In the real world CML would not be probably line, but rather a concave curve, because
borrowing rates are higher than deposit ones and because no lender would consider a borrower,
who borrows on portfolio creation, as riskfree counterparty. But for now we will abstract from
this fact.
Along CML the price of risk can be written for any asset (or portfolio) A that would be included in
CML

E rM r f

2
M

E rA r f

(1)

A2

Risk of any portfolio consisting of 2 assets A and B can be written

P2 A2 wA2 B2 wB2 2 A B A, B wA wB .

(2)

Lets start at the market portfolio M and add some infinitely small portion of M, so that we
would be short (or loosely speaking we would sell) the riskfree asset. The change of
characteristics of the portfolio can be written using (2) and as wM 1

E rM r f

1 E r r E r r .
M

2
M

2
M

2
M

2
M

2
M

(3)

2 is very small, thus omittable, so

E rM r f

E r r .
M

2 M2

2
M

(4)

Similarly we would derive for addition of infinitely small amount of asset A

E rM r f

2
M

E r r .
A

2 A M A,M

(5)

Equating (4) and (5) we get

E rM r f
2

2
M

E rA r f

(6)

2 A M A,M

and after some rearrangement we get CAPM, or the equation of Securities Market Line

E rA r f A,M E rM rf .

(7)

where

A, M

A A, M
.
M

(8)

Luckily, A,M is also regression coefficient for regression function

Est rA E rM r f ,
which is also called as an index model.

2008 Ing. Tom Buus, Ph.D.

(9)

Note: This study material is a reformulation of the conclusions derived in:

Sharpe, Wiliam F. (1964), Capital Asset Prices: A Theory of Market Equilibrium under Conditions
of Risk. The Journal of Finance, Vol. 19, No. 3. (Sep., 1964), pp. 425-442.

2008 Ing. Tom Buus, Ph.D.