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CH 11
CH 11
Main Issues
• Derivations of CAPM
• Implications of CAPM
• Empirical Evidence
11-2 Capital Asset Pricing Model (CAPM) Chapter 11
Contents
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . 11-3
2 The Market Portfolio . . . . . . . . . . . . . . . . . . . . . . 11-4
3 Derivation of CAPM . . . . . . . . . . . . . . . . . . . . . . 11-5
3.1 A Numerical Illustration of CAPM . . . . . . . . . . . . . . . . . 11-6
3.2 A Formal Derivation of CAPM . . . . . . . . . . . . . . . . . . . 11-8
3.3 Implications of CAPM . . . . . . . . . . . . . . . . . . . . . . . . 11-9
4 Understanding Risk in CAPM . . . . . . . . . . . . . . . . . 11-12
5 Applications of CAPM . . . . . . . . . . . . . . . . . . . . . 11-18
6 Empirical Evaluation of CAPM . . . . . . . . . . . . . . . . . 11-20
7 Summary of CAPM . . . . . . . . . . . . . . . . . . . . . . . 11-23
8 Appendix A: Capital Market Line . . . . . . . . . . . . . . . 11-24
9 Appendix B: Extensions of CAPM . . . . . . . . . . . . . . . 11-25
9.1 Multifactor CAPM . . . . . . . . . . . . . . . . . . . . . . . . . 11-25
9.2 Consumption CAPM (CCAPM) . . . . . . . . . . . . . . . . . . . 11-28
10 Homework . . . . . . . . . . . . . . . . . . . . . . . . . . . 11-31
1 Introduction
Portfolio theory analyzes investors’ asset demand given asset
returns.
E [r̃i] = ?
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-4 Capital Asset Pricing Model (CAPM) Chapter 11
MCAPi MCAPi
wi = n = .
j=1 MCAPj MCAPM
3 Derivation of CAPM
Assumptions for this chapter:
Implications:
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-6 Capital Asset Pricing Model (CAPM) Chapter 11
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)
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-8 Capital Asset Pricing Model (CAPM) Chapter 11
Since the net amount invested in the risk-free asset is zero, all
wealth is invested in stocks:
K
W k = MCAPM.
k=1
Thus, the total wealth of investors equals the total value of stocks:
wT = wM .
4. The part of the risk that is correlated with the market portfolio,
the systematic risk, cannot be diversified away.
• Bearing systematic risk needs to be rewarded.
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-10 Capital Asset Pricing Model (CAPM) Chapter 11
2.
where βiM = σiM/σM
The relation between an asset’s risk premium and its market beta
is called the “Security Market Line” (SML).
E[r̃]
SML
6
M
r̄M v
r̄i ` ` ` ` ` ` ` ` ` ` ` ` ` ` ` ` s
`
`
` r̄M − rF
`
`
`
`
rF `
`
`
`
`
` -
βi βM = 1 β
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-12 Capital Asset Pricing Model (CAPM) Chapter 11
where
• E[ε̃i] = 0
• Cov[r̃M, ε̃i] = 0.
• Beta.
• Alpha.
Beta
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
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-14 Capital Asset Pricing Model (CAPM) Chapter 11
Sigma
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
r̃i − rF = βiM (r̃M − rF) + ε̃i .
Var[ε̃] = 0.0700.
σε = 0.2645.
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-16 Capital Asset Pricing Model (CAPM) Chapter 11
Example. Two assets with the same total risk can have very
different systematic risks.
2 = β 2 σ2 + σ2
σ1 1M M 1ε
= 0.19
2 = β 2 σ2 + σ2
σ2 2M M 2ε
= 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
• ...
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-18 Capital Asset Pricing Model (CAPM) Chapter 11
5 Applications of CAPM
Example. Required rates of return on IBM and Dell.
5. Applying CAPM:
r̄IBM = rF + βIBM,VW (r̄VW − rF )
c Jiang Wang
00/03 Resid –Std. Err.– Num.
Ticker Close Std of of Adj. of
Symbol Price Beta Alpha R-Sqr. Dev-N. Beta Alpha Beta Obs.
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: (a) S&P 500 is used as a proxy for the market. (b) Betas are estimated with raw returns, not risk risk premiums. The
Fall 2003
alpha, according to CAPM, is rF (1 − β). (c) Adjusted beta is obtained using other information.
Capital Asset Pricing Model (CAPM)
The dots show the actual average risk premiums from portfolios with
different 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
different betas over different periods. The relation between beta and
actual average return has been much weaker since the mid-1960s.
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-22 Capital Asset Pricing Model (CAPM) Chapter 11
Since mid-1960s:
7 Summary of CAPM
CAPM is attractive:
CAPM is controversial:
1. It is difficult to test:
• difficult to identify the market portfolio
• difficult to estimate returns and betas.
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-24 Capital Asset Pricing Model (CAPM) Chapter 11
E[r̃]
CML
6
m
r̄m v
r̄p ` ` ` ` ` ` ` ` ` ` ` ` ` ` ` ` s
`
`
` r̄m − rF
`
`
`
`
rF `
`
`
`
`
` -
σp σm σ
Thus, even if investors actually invest for a long horizon, CAPM may work
when future investment opportunities are the same as today.
In practice, however:
Thus
• They may accept lower expected returns on assets that help to hedge
against such shifts.
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-26 Capital Asset Pricing Model (CAPM) Chapter 11
Example. Graduating MBAs saving for retirement may worry about a fall in
future real interest rates.
• They might not be content with holding the market portfolio and the
riskless asset.
• They might overweight assets that do well if real interest rates fall.
• They would be willing to accept low returns on these assets (relative to
CAPM predictions).
Multi-factor CAPM tries to model the two types of systematic risk and how
these risks are priced:
• Find portfolios of traded securities that are highly correlated with these
factors.
where r̄f k is the return on the portfolio that is correlated with only the
k-th factor.
• The factor beta’s can be estimated using regression analysis, as in the case
of CAPM.
(a) temporal
(b) intertemporal.
• Model does may not identify the macroeconomic variables that constitute
intertemporal risks.
• Model does may not specify the relative importance of these intertemporal
risks.
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-28 Capital Asset Pricing Model (CAPM) Chapter 11
However, there is another way to characterize how investors perceive the risk
in asset returns — a way that allows us to collapse many risk factors into one.
1. Consume $1 today
• achieve utility u0 (c0 ), or
2. Invest the $1 in asset i
• receive $(1 + r̃i ) tomorrow
• consume the payoff, and achieve utility u1 (c̃1 )(1 + r̃i ).
Thus
1
r̄i − rF = − Cov u1 (c̃1 ), r̃i .
E u1 (c̃1 )
Observation: The above must be true for any investor who is at optimum.
(a) For Cov u1 (c̃1 ), r̃i > 0
Thus, an asset’s risk is measured by the covariance between its return and
investors’ marginal utility.
c Jiang Wang Fall 2003 15.407 Lecture Notes
11-30 Capital Asset Pricing Model (CAPM) Chapter 11
1
Et [r̃it+1 ] − rFt = − Covt ut+1 (c̃t+1 ), r̃it+1 .
Et u1 (c̃t+1 )
Advantages of CCAPM:
Weaknesses of CCAPM:
10 Homework
Readings:
• BKM Chapters 9.
Assignment:
• Problem Set 8.
c Jiang Wang Fall 2003 15.407 Lecture Notes