1

Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Chapter 8

Capital Asset Pricing

and Arbitrage
Pricing Theory
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2001 The McGraw-Hill Companies, Inc. All

Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Capital Asset Pricing Model (CAPM)

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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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

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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Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Assumptions (cont.)
Information is costless and available to
all investors
Investors are rational mean-variance
optimizers
Homogeneous expectations

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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

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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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Resulting Equilibrium Conditions

(cont.)
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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Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Capital Market Line

E(r)

E(rM)

CML

rf
m
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Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Slope and Market Risk Premium

M
rf
E(rM) - rf

=
=
=

Market portfolio
Risk free rate
Market risk premium

E(rM) - rf

Market price of risk

Slope of the CAPM

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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Expected Return and Risk on

Individual Securities
The risk premium on individual
securities is a function of the individual
securitys contribution to the risk of the
market portfolio
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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10

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Security Market Line

E(r)
SML
E(rM)
rf
M = 1.0
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11

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

SML Relationships
= [COV(ri,rm)] / m2
Slope SML =

E(rm) - rf

= market risk premium

SML = rf + [E(rm) - rf]

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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Sample Calculations for SML

E(rm) - rf = .08 rf = .03
x = 1.25
E(rx) = .03 + 1.25(.08) = .13 or 13%
y = .6
e(ry) = .03 + .6(.08) = .078 or 7.8%
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13

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Graph of Sample Calculations

E(r)
SML
Rx=13%
Rm=11%
Ry=7.8%
3%

.08

.6 1.0 1.25
y m x
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14

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Disequilibrium Example
E(r)
SML
15%
Rm=11%
rf=3%
1.0 1.25
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Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Disequilibrium Example
Suppose a security with a of 1.25 is
offering expected return of 15%
According to SML, it should be 13%
Underpriced: offering too high of a rate
of return for its level of risk

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Essentials of Investments

Bodie Kane Marcus

Fourth
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Security Characteristic Line

Excess Returns (i)
SCL

.
.
.
.
.
.
. . .
.
.
.
.
.
.
.
.
.
.
.
. .
.
.
Excess returns
.
.
.
on market index
.
.
.
.
.
.
.
.
.
. . . .
.
.
.
.
.
.. . . .
Ri = i + i Rm + e i

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17

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Using the Text Example p. 245, Table

8.5:
Jan.
Feb.
.
.
Dec
Mean
Std Dev
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Excess
GM Ret.

Excess
Mkt. Ret.

5.41
-3.44
.
.
2.43
-.60
4.97

7.24
.93
.
.
3.90
1.75
3.32
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18

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Regression Results:
rGM - rf =

+ (rm - rf)

Estimated coefficient -2.590

Std error of estimate (1.547)
Variance of residuals = 12.601
Std dev of residuals = 3.550
R-SQR = 0.575
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1.1357
(0.309)

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19

Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Arbitrage Pricing Theory

Arbitrage - arises if an investor can
construct a zero investment portfolio
with a sure profit
Since no investment is required, an
investor can create large positions to
secure large levels of profit
In efficient markets, profitable arbitrage
opportunities will quickly disappear
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20

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Arbitrage Example from Text pp. 255257

Current
Stock Price$
A
10
B
10
C
10
D
10

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Expected
Return%
25.0
20.0
32.5
22.5

Standard
Dev.%
29.58
33.91
48.15
8.58

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21

Essentials of Investments

Bodie Kane Marcus

Fourth
Edition

Arbitrage Portfolio

Portfolio
A,B,C
D

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Mean
Return

Stan.
Dev.

Correlation
Of Returns

25.83

6.40

0.94

22.25

8.58

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22

Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

Arbitrage Action and Returns

E. Ret.
* P
* D
St.Dev.
Short 3 shares of D and buy 1 of A, B & C to form
P
You earn a higher rate on the investment than
you pay on the short sale
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23

Bodie Kane Marcus

Essentials of Investments

Fourth
Edition

APT and CAPM Compared

APT applies to well diversified portfolios and
not necessarily to individual stocks
With APT it is possible for some individual
stocks to be mispriced - not lie on the SML
APT is more general in that it gets to an
expected return and beta relationship without
the assumption of the market portfolio
APT can be extended to multifactor models

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