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Main Issues
Derivation of CAPM
Applications of CAPM
Empirical Evidence
APT
Chapter 8 CAPM and APT 8-1
1 Introduction
Portfolio theory analyzes investors asset demand given asset
returns.
E [
ri ] = ?
Fall 2006
c J. Wang 15.401 Lecture Notes
8-2 CAPM and APT Chapter 8
MCAPi MCAPi
wi = n = .
j=1 MCAPj MCAPM
3 Derivation of CAPM
Assumptions for this chapter:
Implications:
Fall 2006
c J. Wang 15.401 Lecture Notes
8-4 CAPM and APT Chapter 8
There are only three risky assets, A, B and C. Suppose that the
tangent portfolio is
Investor Riskless A B C
1 100 100 200 100
2 200 200 400 200
3 -300 450 900 450
Total 0 750 1500 750
Claim:
5.00
4.50
Efficiency frontier
4.00
3.50
Return (%, per month)
3.00
T=M
2.50
2.00
1.50
1.00
0.50
0.00
0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0
Standard Deviation (%, per month)
Fall 2006
c J. Wang 15.401 Lecture Notes
8-6 CAPM and APT Chapter 8
4 The CAPM
Expected return.
rp
= ri rF.
wi
Risk.
w1 r1 w2 r2 w n rn
w1 r1 22
w1 w1 w2 12 w1 wn 1n
1
w2 r2 w2 w1 21 22
w2 w2 wn 2n
2
.. .. ... ..
. . .
wn rn wn w1 n1 wn w2 n2 22
wn n
The sum of the entries of the i-th-row and the i-th column is the
total contribution of asset i to portfolio variance:
n
wi2 i2 + 2 wi wj ij .
j=i
= 2 Cov[
ri, rp].
p 1 p2
= = Cov[
ri , rp]/p = ip/p.
wi 2p wi
Fall 2006
c J. Wang 15.401 Lecture Notes
8-8 CAPM and APT Chapter 8
5.00
4.50
Efficiency frontier
4.00
3.50
Return (%, per month)
3.00
T
2.50
2.00
1.50
1.00
0.50
0.00
0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0
Standard Deviation (%, per month)
Re-writing
ri rF rM rF
=
(iM/M) M
iM
ri rF = 2
rM rF) = iM (
( rM rF )
M
where
2
iM = iM/M
Fall 2006
c J. Wang 15.401 Lecture Notes
8-10 CAPM and APT Chapter 8
r
SML
6
M
r M v
r ` ` s
i ` ` ` ` ` ` ` ` ` ` ` ` ` ` `
`
` r rF
M
`
`
`
`
r F
`
`
`
`
`
` -
i M = 1
Fall 2006
c J. Wang 15.401 Lecture Notes
8-12 CAPM and APT Chapter 8
rM rF) + i
ri rF = i + iM (
where
E[
i ] = 0
Cov[
rM, i ] = 0.
Beta.
Alpha.
Beta
rM rF) + i
ri rF = i + iM (
2 2
1.5 1.5
1 1
return
return
0.5 0.5
0 0
0.5 0.5
10 20 30 40 10 20 30 40
time time
2 2
1.5 1.5
asset return
asset return
1 1
0.5 0.5
0 0
0.5 0.5
0.4 0.6 0.8 1 1.2 0.4 0.6 0.8 1 1.2
market return market return
Fall 2006
c J. Wang 15.401 Lecture Notes
8-14 CAPM and APT Chapter 8
Sigma
rM rF) + i
ri rF = i + iM (
1.5 1.5
1 1
return
return
0.5 0.5
0 0
0.5 0.5
10 20 30 40 10 20 30 40
time time
1.5 1.5
1 1
return
return
0.5 0.5
0 0
0.5 0.5
10 20 30 40 10 20 30 40
time time
systematic non-systematic
component component
ri rF = rM rF )
iM ( + i .
Var[
] = 0.0700.
= 0.2646.
Fall 2006
c J. Wang 15.401 Lecture Notes
8-16 CAPM and APT Chapter 8
Example. Two assets with the same total risk can have very
dierent systematic risks.
2 = 2 2 + 2
1 1M M 1
= 0.19
2 = 2 2 + 2
2 2M M 2
= 0.19.
However
2 (1.5)2 (0.2)2
R1 = = 47%
0.19
2 (0.5)2 (0.2)2
R2 = = 5%.
0.19
Alpha
rM rF) + i
ri rF = i + iM (
...
Fall 2006
c J. Wang 15.401 Lecture Notes
8-18 CAPM and APT Chapter 8
6 Applications of CAPM
Example. Required rates of return on IBM and Dell.
5. Applying CAPM:
rIBM = rF + IBM,VW (
rVW rF )
AALA AmerAlia 2.250 -2.25 10.05 0.03 42.72 1.30 6.06 -1.15 60
AOL America Online 67.438 2.40 4.12 0.25 17.17 0.52 2.44 1.93 60
GNLK GeneLink 0.290 -7.74 16.15 0.44 37.30 2.10 9.92 -4.79 17
GM General Mtrs 82.813 1.01 -0.57 0.27 6.98 0.21 0.99 1.01 60
TSN Tyson Foods 11.125 1.13 -2.31 0.23 8.55 0.26 1.21 1.09 60
Note
Fall 2006
c J. Wang 15.401 Lecture Notes
8-20 CAPM and APT Chapter 8
The dots show the actual average risk premiums from portfolios with
dierent betas.
2. CAPM does not seem to work well over the last 30 years:
The dots show the actual average risk premiums from portfolios with
dierent betas over dierent periods. The relation between beta and
actual average return has been much weaker since the mid-1960s.
Fall 2006
c J. Wang 15.401 Lecture Notes
8-22 CAPM and APT Chapter 8
Since mid-1960s:
8 Summary of CAPM
CAPM determines risk-return trade-o:
CAPM is controversial:
Fall 2006
c J. Wang 15.401 Lecture Notes
8-24 CAPM and APT Chapter 8
rM rF) + + biN (
ri rF = i + biM ( rN rF) + i
where
ri rF = biM(
rM rF) + + biN(
rN rF)
where
(i.e., i = 0).
ri rF = biM(
rM rF) + biN(
rN rF) + i .
Suppose that
rF rM rF rN rF
5% 8% 2%
Asset bM bN
A 1.0 1.0
B 1.5 0.2
C 1.0 0.6
Fall 2006
c J. Wang 15.401 Lecture Notes
8-26 CAPM and APT Chapter 8
Suppose that rA was instead 10% (and it has only factor risks).
10 Implementation of APT
The implementation of APT involves three steps:
2. Model itself does not say what the right factors are.
Fall 2006
c J. Wang 15.401 Lecture Notes
8-28 CAPM and APT Chapter 8
11 Homework
Readings:
BKM Chapters 9.
Assignment:
Problem Set 5.