THE CAPITAL ASSET PRICING MODEL

(CAPM)

DEFINITION
A model that describes the relationship
between risk and expected return and that
is used in the pricing of risky assets (stocks,
securities, derivatives) or Portfolio

History
CAPM was build on the earlier work of
Harry Markowitz on
Modern Portfolio Theory (MPT) and
Diversification
The CAPM was introduced independently by
Jack Trevnor (1961, 1962),
William F. Sharpe (1964),
Jhon Lintner(1965) and
Jan Mossin (1966)

History
Nobel Memorial Prize in Economics in 1990
Jointly received by Sharpe, Markowitz and Merton
Miller
(for CAPM contribution to field of Financial Economics)
Black CAPM or Zero-beta CAPM by Fischer Black
(1972)
another version of CAPM
that does not assume the existence of a riskless asset.
more robust version against empirical testing and was
influential in the widespread adoption of the CAPM.

Background of CAPM
Modern Portfolio
Theory

Capit
al
Mark
et
Theor
y

CAPM

Arbitrag
e
Pricing
Theory

Background of CAPM
CAPM is evolved by Markowitz after the
Modern Portfolio Theory (MPT) of
Markowitz,
MPT describes,
HOW investors should ACT in selecting
an Optimal Portfolio of Risky
securities based on using the full
information set about securities

Background of CAPM
(Modern Portfolio Theory)
Main Objective of MPT is
to maximize Profits and
Reducing the diversifiable risk
by selecting an efficient portfolio that
is also an Optimal Portfolio
Optimal portfolio
the one that provides the most
satisfaction the greatest return for
an investor based on his tolerance for
risk.

Background of CAPM
(Modern Portfolio Theory)
Efficient Portfolio has
the highest expected return for
a given level of Risk,
OR stated in another terms
The lowest level of risk for a
given level of expected return

Background of CAPM
(Modern Portfolio Theory)
for determining Efficient Portfolio, Inputs for
the securities being considered includes
Expected returns of individual securities,
Standard Deviations of individual securities,
Correlation Coefficient between securities
And therefore Securities Weights of
Portfolio are the variably manipulated based
on above statistical techniques to determine
efficient portfolios

Background of CAPM
(Modern Portfolio Theory)
Efficient Frontier:
the investment Opportunity Set
Construct a risk/return plot of all the
feasible portfolios-those that are
actually attainable.
consists of the set of all efficient
portfolios that yield the highest return
for each level of risk

Background of CAPM
(Modern Portfolio Theory)
Efficient Frontier:
Expected Return

No points plot above

the line

All portfolios
on the line
are efficient

100% investment in security

with highest E(R)

Points below the efficient

frontier are dominated

100% investment in minimum

variance portfolio
Standard Deviation

11

Background of CAPM
(Modern Portfolio Theory)
Indifference Curves:
describe an individual investors
preferences for Risk and Return
Investors have infinite number of
indifference curves.
Each curve is equally desirable to a
particular investor (i.e. They provide same
level of Utility)
Indifference curves cannot intersect since
they represent different levels of desirability

Background of CAPM
(Modern Portfolio Theory)
Indifference Curves:

Risk-Averse Investors has upward

sloping indifference curves
Higher Indifference curves are more
desirable than lower indifference
curves
The greater the slope of Indifference
curve, greater is the Risk Aversion of
investors
Farther an indifference curve is from
the horizontal axis, the greater the

Indifference Curves

Indifference Curves
The utility of these risk-indifference
curves is that they allow the
selection of the optimum portfolio
out of all of those that are attainable
by combining these curves with the
efficient frontier.

Selecting an Optimal
Portfolio
One of the attainable indifference curves
intersects the efficient frontier at a single
point, that single point is the Optimal
portfolio
(In other words),
The efficient frontier can be combined
with an investors utility function to find
the investors optimal portfolio, the
portfolio with the greatest return for the
risk that the investor is willing to accept.

Selecting an Optimal
Portfolio

Important Conclusions
about MPT
Two parameter model i.e.,
Risk-Return model OR
Mean-Variance model
(because investors are assumed to make
decisions on the basis of two parameters; Risk
and Return)
Does not addresses the issue of investors
using borrowed money along with their own
portfolio funds to purchase a portfolio of risky
assets i.e., investors are not allowed to use
Leverage (Risk Free Asset utilization)

Gaps in MPT theory

Few Queries arises after MPT theory

What happens if all investors seek

portfolios of risky securities using
Markowitz Framework under Idealized
conditions?
How will this affect equilibrium Security
Prices and Returns?
(In other words) How does Optimal
Diversification affect the market prices
of securities?

Gaps in MPT theory

Under Ideal conditions , what is the
Risk-Return trade-off that investors
face?
In general we wish to examine the
models that explain security prices
under conditions of market
equilibrium, these are
Asset Pricing Models or
Models for valuation of Risky
Securities

Capital Market Theory

(Theory of CAPM)
Modern
Portfolio
Theory
Hypothesizes that
how investors
should behave in
selecting an Optimal
Portfolio of
Securities?

Capita
l
Marke
t
Theor
y

Hypothesizes
that how
investors do
behave?

Capital Market Theory

(Theory of CAPM)
-----An Extension of Portfolio
Theory
Answers about
What happens if all investors seek
portfolios of risky securities using
Markowitz Framework under Idealized
conditions?

Assumptions of Capital Market

Theory
(Theory of CAPM)
Assumption of Markowitz Portfolio
Theory:-

Each investor is assumed to

diversify
his
or
her
portfolio
according
to
Markowitz
Model,
choosing a location on the efficient
frontier that matches his or her
return-risk preferences

Assumptions of Capital Market Theory

(Theory of CAPM)
Additional Assumptions to make individuals
more alike:
All investors can borrow or lend money at the
Risk-Free rate of return (RF)
All investors have Homogeneous expectations
i.e., have identical probability distributions for
Expected returns
Variance of returns and
Correlation Matrix
(Therefore using the same set of security prices and a
risk-free rate, all investors use the same information to
generate an efficient frontier)

Assumptions of Capital Market Theory

(Theory of CAPM)
All investors have same one-period time
horizon
No transaction costs
No personal income taxes---investors are
indifferent between capital gains and
dividends
No inflation
Large number of Investors---and Investors
are price takers ( Prices are unaffected by
their own trades)

Evolution of Capital Market

Theory
The Introduction of Risk-Free Asset
allows us to develop Capital Market
Theory from Portfolio Theory as
The first assumption of CMT is
All investors can borrow or lend
money at the Risk-Free rate of return
(RF)

Evolution of Capital Market

Theory
Risk-Free Asset (Rf)
Which has no Risk of Default
One with a certainty of expected return

(Amount of money to be received at the end

of holding period is known with certainty at
the beginning of period)
And Expected Return = Nominal Return
Variance of a return = Zero
Covariance between Risk-free asset and Risky
asset i = Zero
Example : Treasury Securities

Evolution of Capital Market

Theory
With the introduction of Rf Assets,
Investors can now invest:

Part of their wealth in the risk

free assets by lending
And remainder in any of the risky
portfolios in the Markowitz
efficient set

Evolution of Capital Market

Theory
When a risk-free investment is
available, the shape of the efficient
frontier changes completely, and
Leads to general theory for Pricing
Assets under uncertainty
And introduced Capital Market
Line

THE CAPITAL MARKET LINE

THE CAPITAL MARKET LINE

CML

rP
M
rfr

P
30

THE CAPITAL MARKET LINE

The straight line (CML) from Rf to efficient
frontier at point M, RfM, contains the
superior Lending Portfolios, i.e
Risk Free Lending OR Risk Free
Investing
Purchase of Risk less Assets such as
Treasury Bills
Or lending money to the issuer of
securities such as U.S government

THE CAPITAL MARKET LINE

Point M represents 100 % of an
investors wealth in the Risky Asset
Portfolio M or Market Portfolio, and is
completely diversified
Portfolio M contains only the Market
Risk(systematic Risk)
Now we assume that Investor can
also borrow at Rf rate

THE CAPITAL MARKET LINE

Borrowing the additional investable
funds and investing them together
with the Investors own wealth allows
investor to seek higher expected
returns while assuming greater Risk
The straight line RfM is now
extended upward into Rf-M-L Capital
Market Line

THE CAPITAL MARKET LINE

Definitions:
CML specifies the equilibrium
relationship between expected return
and Risk for efficient portfolios
The straight line ,CML, depicts
the equilibrium conditions that prevail
in the market for Efficient Portfolios
consisting of Optimal Portfolio of
Risky and Risk Free Assets

slope of the CML

slope of the CML

Note that the Market Risk Premium (MRP)
is defined as:
MRP=E(Rmkt)Rrf
so the slope of the CML the Sharpe
ratio for the Market Portfolio is:
Slope of CML=E(Rmkt)Rrf = MRP
mkt mkt
Slope of CML is the market price of risk
for efficient portfolios

Equation for CML

As Rrf is the intercept and Risk is
measured by the standard deviation,
So

E(Rp ) = Rrf

mkt

E(Rmkt)Rrf. p

Equation for CML

Where
E(Rp) = the expected return on any efficient
portfolio on the CML
E(Rmkt)= the expected return on Market
Portfolio M
p= the S.D of the Efficient Portfolio being
considered
mkt = the S.D of the returns on the Market
Portfolio

Criticism of CML
(and Evolution of CAPM)
CML applies only to Efficient Portfolios
(since only efficient portfolios are on Efficient
frontier)

CML cannot be used to assess the equilibrium

expected return on a Single Security
CML cannot be used to assess expected
return on a Inefficient Portfolios

Above Criticism on CML leads to

formulation of CAPM

CAPM
Capital Assets Pricing Model
The theory regarding asset prices and
markets
Model for valuation or pricing of Risky assets
Model that explain security prices under
conditions of market equilibrium

CAPM
It allows us :
To measure relevant risk of an
individual security
To assess the relationship between
Risk and Return expected from
Investing

Assumptions of CAPM
All investors will hold Market
Portfolio
The benchmark portfolio against which
other portfolios are measured
Well diversified portfolio
Has only market risk or systematic risk
Investors are interested in Portfolio risk
rather than individual security risk

CAPM Theory
Although all investors hold diversified
portfolios BUT
What happens when an Investor
adds a security to a large portfolio?
The contribution of individuals stock
risk to the riskiness of well diversified
portfolio leads to the formulation of
CAPM

CAPM Theory
When an investor adds security to a
large portfolio, what matters is
the securitys average covariance
with the other securities in a
portfolio
Major Conclusion of CAPM
Relevant risk of any security is the
amount of risk that security
contributes to a well-diversified
portfolio

Derivation of CAPM
Model
the Capital Market Theory Model is
E(Rp ) = Rrf + E(Rmkt)Rrf. p
mkt
If expected return of stock i is related to
its covariance with the Market Portfolio,
then
E(Ri ) = Rrf
2mkt

E(Rmkt)Rrf. Covi,mkt

Derivation of CAPM
Model
The new derived equation states that
,
The expected return on any
Security is the sum of Risk free
rate and Risk Premium
Risk premium reflects,
Assets covariance with the market
portfolio

Derivation of CAPM
Model
E(Ri ) = Rrf

E(Rmkt)Rrf. Covi,mkt

2mkt
Where,

E(Rp) = the expected return on any efficient

portfolio on the CML
E(Rmkt)= the expected return on Market Portfolio M
2mkt = the variance of the returns on Market
Portfolio
Covi,mkt =
the Covariance of the stock with the
market

Derivation of CAPM
Model
BETA
From the following model,
E(Ri ) = Rrf
Covi,mkt

2mkt

Beta = Covi,mkt
2mkt

E(Rmkt)Rrf.

Derivation of CAPM
Model
%) R

E ( R%
)

E
(
R
i
f
i
m
f

where E ( R%
i ) expected return on security i
R f risk-free rate of interest

i beta of Security i
E ( R%
m ) expected return on the market

Derivation of CAPM
Model
BETA
The relative measure of Systematic Risk of any stock
Measures the Risk of an Individual stock relative to
market portfolio of all stocks
Sensitivity of the securitys return relative to the
Market Return
Beta relates the covariance of an asset with the
market portfolio to the variance of the market
portfolio

Beta = Covi,mkt
2mkt

Derivation of CAPM
Model
BETA
Aggregate market has a beta of 1
More Volatile (Risky assets) have
betas larger than 1
Less Risky stocks have betas less
than one

Security Market Line

(SML)
The graphical depiction of CAPM
CAPM theory shows a linear
relationship between an Assets risk
and required rate of return for any
asset, security, or portfolio.
This linear relationship is called SML

Security Market Line

(contd)
Expected Return

E(R)
Market Portfolio

Rf

1.0

Beta

53

Implications of CAPM
SML has important implications for
security prices in equiblirium
In equiblirium expected return of
security should be that needed to
compensate investors for the
Systematic Risk
Knowing the beta for any stock , we
determine the required return for any
stock

Implications of CAPM
What happens if investors
determine that security does
not lie upon SML
Undervaluation
Security lies above SML

Overvaluation
Security lies below SML