Chapter 2: Risk and return: mean–variance analysis and the CAPM

Chapter 2: Risk and return:

mean–variance analysis and the CAPM

Aim of the chapter

The aim of this chapter is to derive the capital asset pricing model (CAPM)
enabling us to price financial assets. In order to do so, we introduce the
mean–variance analysis setting, in which investors care solely about
financial assets’ expected returns and variances of returns, as well as the
statistical tools enabling us to calculate portfolios’ expected returns and
variances of returns.

Learning objectives
At the end of this chapter, and having completed the essential reading and
activities, you should be able to:
• discuss concepts such as a portfolio’s expected return and variance as
well as the covariance and correlation between portfolios’ returns
• calculate portfolio expected return and variance from the expected
returns and return variances of constituent assets
• describe the effects of diversification on portfolio characteristics
• derive the CAPM using mean–variance analysis
• describe some theoretical and practical limitations of the CAPM.

Essential reading
Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,
Mass.; London: McGraw-Hill, 2002) Chapters 4 and 5.

Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapters 8 and 9.
Copeland, T. and J. Weston Financial Theory and Corporate Policy.
(Reading, Mass.; Wokingham: Addison-Wesley, 2005) Chapters 5 and 6.
Roll, R. ‘A Critique of the Asset Pricing Theory’s Texts. Part 1: On Past and
Potential Testability of the Theory’, Journal of Financial Economics 4(2)
1977, pp.129–76.

Introduction
In Chapter 1 we examined the use of present-value techniques in the
evaluation of physical investment projects and in the valuation of primitive
financial assets (i.e. stocks and bonds). A key input into NPV calculations
is the rate of return used in the construction of the discount factor but,
thus far, we have said little regarding where this rate of return comes
from. Our objective in this chapter is to demonstrate how the risk of a
given security or project impacts on the rate of return required from it and
hence affects the value assigned to that asset in equilibrium.
We begin by introducing the basic statistical tools that will be needed
in our analysis, these being expected values, variances and
covariances. This leads to an analysis of the statistical characteristics
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92 Corporate finance

of portfolios of financial assets and ultimately to a presentation of the

standard mean–variance optimisation problem. The key result of mean–
variance analysis is known as two-fund separation, and this result
underlies the capital asset pricing model, which we will present next.

Statistical characteristics of portfolios

A portfolio is a collection of different assets held by a given investor.
For example, an American investor may hold 100 Microsoft shares and
650 shares of Bethlehem Steel and therefore holds a portfolio comprising
two assets. The objective of this section is to arrive at the statistical
characteristics of the return on the entire portfolio, given the statistical
features of each of the constituent assets. The key statistical measures used
are expected returns and return variances or standard deviations.
The expected return on a given asset can be thought of as the reward
gained from holding it, whereas the return variance is a measure of total
asset risk.
Let us define notation. First, we should clarify the way in which we are
thinking about asset returns. The return on an asset is assumed to be a
random variable with known distributional characteristics. Each individual
asset is assumed to have an expected return of E(rj) and return variance
σ2j. Assets i and j are assumed to have covariance σij . Similarly, we denote
the expected return of the portfolio held as E(Rp) and its variance by σ2P.
Finally, we assume that an investor can pick from N different stocks when
forming his portfolio.
Returning to the example of the American investor given above, assume
that the market price of Microsoft shares is 130 and that of Bethlehem
Steel is 10.1 Hence, given the numbers of each share held, the total value 1
These prices are in US
of this investor’s portfolio is $195. We further assume that the expected cents.
returns on Microsoft and Bethlehem Steel are 10 per cent and 16 per cent
respectively, whereas their variances are 0.25 and 0.49.
We are now in a position to define the share of the entire portfolio value
that is contributed by each individual stockholding. These are referred
to as portfolio weights. The portfolio weight of Bethlehem Steel, for
example, is simply the value of the Bethlehem Steel holding divided by
$195 (i.e. 1/3 or approximately 33.3 per cent). Hence our US investor
allocates 1/3 of every dollar invested to Bethlehem Steel stock.

Activity
Calculate the portfolio weight for Microsoft, using the method presented above.

From the calculations undertaken it is clear that the sum of portfolio

weights must be unity. Each portfolio weight represents the share of total
portfolio value contributed by a given asset. Obviously, aggregating these
shares across all assets held will give a result of unity. Hence, extending
the notation presented above, we denote the portfolio weight on asset i by
ai, and the preceding argument implies that Σα1= 1.
Our American investor now knows the statistical characteristics of the
return on each of the assets she holds, plus how to calculate the portfolio
weight on each of the assets. What she would really like to know now is
how to construct the return characteristics for the entire portfolio (i.e.
she’s concerned about the risk and reward associated with her entire
investment). In order to do this we will need to introduce some basic
properties of expectations, variances and covariances.

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 Chapter 2: Risk and return: mean–variance analysis and the CAPM

Expectations, variances and covariances

Consider two random variables, x and y. The expected values and
variances of these variables are E(x), E(y), σ2x and σ2y. The covariance
between the random variables is σxy.
Form an arbitrary linear combination of these two random variables and
denote it P (i.e. P = ax + by, where a and b are constants). We wish to
know the expected return and variance of the new random variable P.
These are calculated as follows:
E(P) = aE(x) + bE(y) (2.1)
σ = a σ + b σ + 2abσxy.
2
P
2 2
x
2 2
y
(2.2)
The preceding results are readily extended to the case where more than
two random variables are linearly combined. Consider N random variables
denoted xi, where i runs from 1 to N. Denote their expected values and
variances as E(xi) and σ2i. The covariance between xi and xj is σij. Again
we form a linear combination of the random variables, denoted again by
P, using an arbitrary set of constants denoted ai. The expected value and
variance of the random variable P are given by:
N
E(P) = ∑ a1 E ( x1) (2.3)
i =1
N
σP2 = ∑ a i2 σ i2 + ∑a i a j σ ij. (2.4)
i =1 i≠ j

Given that the returns on individual assets are assumed to be random

variables with known distributional characteristics, the statistical results
given above allow us to calculate portfolio returns and variances very
simply.
In addition to the data on Microsoft and Bethlehem Steel provided earlier,
we also need to know the covariance between Microsoft and Bethlehem
Steel returns in order to determine the statistical characteristics of
portfolios of these two assets. However, rather than using covariances, we
shall work throughout the rest of this analysis with correlation coefficients.
The relationship between correlations and covariances is given below.

Covariances and correlations

Assume two random variables, x and y, with variances denoted by σ2x and
σ2y. The covariance between the random variables is σxy. The correlation
coefficient is defined as follows:
σ
ρxy = σ xyσ , (2.5)
x y

that is, the correlation between the two random variables is simply the
covariance, divided by the product of the respective standard deviations.
Clearly, knowledge of the correlation and the variances of the two random
variables allows one to retrieve the covariance between the two random
variables.
If we again define a linear combination of the two random variables, P,
using arbitrary constants a and b, the expression for the variance of the
linear combination can be rewritten using the correlation as follows:
σ2p = a2σ2x + b2σ2y + 2abrxyσxσy. (2.6)
This is a straightforward substitution of equation 2.5 into equation 2.2.
Now we are in a position to calculate the characteristics of our American
investor’s portfolio. Let us take the simplest possible case first and assume
that the returns are uncorrelated (i.e. rxy = 0). Recalling that the portfolio
weights on Microsoft and Bethlehem Steel are 2 and 1 respectively, we
3 3
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92 Corporate finance

can use equations 2.1 and 2.6 to derive the expected return and variance
of the investor’s portfolio. These calculations yield:

E ( R p) = 2
3 (0.1) + 1
3 (0.16) = 0.12 = 12 % (2.7)

σP2 = ( 23 ( 2 (0.25) + ( 13 ( 2 (0.49) = 16.6 %. (2.8)

Hence, as we would expect, the expected portfolio return lies between

the returns on the individual assets. The portfolio variance, however, is
actually less than that on the return of either of the component assets (i.e.
the risk associated with the portfolio is lower than the risks associated
with either individual asset). This result is one that should be kept in mind
and is the focus of the next section.
Now let’s change our assumption regarding the correlation between the
two asset returns. Assume now that rxy = 0.5. Obviously, the expected
portfolio return won’t change (as equation 2.1 doesn’t involve the
correlation or covariance at all). The portfolio variance now becomes:
σP2 = ( 23 ( 2 (0.25) + ( 13 ( 2 (0.49) + 2 ( 13 ( ( 23 ( × 0.5 × 0.5× 0.7 = 24.3%. (2.9)
The portfolio variance has obviously increased, although it is still less than
the return variances of either component assets.

Activity
Assume that rxy = – 0.5. Calculate the portfolio return variance in this case, using the
data on portfolio weights and asset return variances given above.

Now, given the expected returns, return variances and covariances for
any set of assets, we should be able to calculate the expected return and
variance of any portfolio created from those assets. At the end of this
chapter, you will find activities that require you to do precisely this, along
with solutions to some of these activities.

Diversification
A point that we noted from the calculations of expected portfolio returns
and variances above was that, in all of our calculations, the variance of the
portfolio return was lower than that on any individual component’s asset
return.2 Hence, it seems as though, by forming bundles of assets, we can 2
Note that this result
eliminate risk. This is true and is known as diversification: through holding does not hold in general
(i.e. it may be the case
portfolios of assets, we can reduce the risk associated with our position.
that the return variance
Why is this the case? The key is that, in our prior analysis and in real stock of a portfolio exceeds
return data, the correlations between returns are less than perfect. If two the return variance of
returns are imperfectly correlated it implies that when returns on the first are one of the component
assets).
above average, those on the second need not be above average. Hence, to an
extent, the returns on such assets will tend to cancel each other out, implying
that the return variance for a portfolio of these stocks will be smaller than
the corresponding weighted average of the individual asset variances.
To illustrate this point in a general setting, consider the following scenario.
An investor holds a portfolio consisting of N stocks, with each stock having
the same portfolio weight (i.e. each stock has portfolio weight N-1). Denote
the return variances for the individual assets by σ2i where i = 1 to N, and
the covariance between returns on assets i and j by σij. Using equation 2.4,
the variance of the investor’s portfolio return can be written as:
N
σP2 = 12 ∑ σi2 + N12 ∑ σij . (2.10)
N i =1 i≠ j

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 Chapter 2: Risk and return: mean–variance analysis and the CAPM

Examining the second term of equation 2.10, the existence of N

component assets implies that the summation for all i not equal to j
involves N(N – 1) terms. Obviously the summation in the first term of 2.10
involves N terms. Hence, defining the average variance of the N assets as
σ–2 and average covariance across all assets as C, 2.10 can be rewritten as:
N N (N – 1( C
σP2 = 2 σ 2 + . (2.11)
N N2
Equation 2.11 obviously simplifies to the following:

N ( N (
σP2 = 12 σ 2 + 1 – 1 C . (2.12)

Now we ask the following question. How does the portfolio variance change
as the number of assets combined in the portfolio increases towards infinity
(i.e. N → ∞). It is clear from 2.12 that, as the number of assets held increases,
the first term will shrink towards zero. Also, as N increases the second term
in 2.12 tends towards C. Together, these observations imply the following.
1. The portfolio variance falls as the number of assets held increases.
2. The limiting portfolio return variance is simply the average covariance
between asset returns: this average covariance can be thought of as
the risk of the market as a whole, with the influence of individual asset
return variances disappearing in the limit.
The moral of the preceding statistical story is clear. Holding portfolios
consisting of greater and greater numbers of assets allows an investor to reduce
the risk he or she bears. This is illustrated diagrammatically in Figure 2.1.

Figure 2.1

Mean–variance analysis
In the preceding two sections, we have demonstrated two important facts:
1. The expected return on a portfolio of assets is a linear combination of
the expected returns on the component assets.
2. An investor holding a diversified portfolio gains through the reduction
in portfolio variance, when asset returns are not perfectly correlated.
In this section, we use these facts to characterise the optimal holding of
risky assets for a risk-averse agent. Our fundamental assumption is that all
agents have preferences that only involve their expected portfolio return
and return variance. Utility is assumed to be increasing in the former
and decreasing in the latter. For illustrative purposes we begin using the
assumption that only two risky assets are available. The results presented,
however, generalise to the N asset case.
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92 Corporate finance

To begin, assume there is no risk-free aset. The investor can hence only
form his or her portfolio from risky assets named X and Y. These assets
have expected returns of E(Rx) and E(Ry) and return variances of σ2x and σ2y.
The first question the investor wishes to answer is how the characteristics
of a portfolio of these assets (i.e. portfolio expected return and variance)
change as the portfolio weights on the assets change. Given equation 2.6,
the answer to this question is obviously dependent on the correlation
between the returns on the two assets.
First assume the assets are perfectly correlated and, further, assume asset
X has lower expected returns and return variance than asset Y. We form a
portfolio with weights α on asset X and 1 – α on asset Y. Equation 2.6 then
implies that the portfolio variance can be written as follows:
σ2P = (ασx + (1 – α)σy )2. (2.13)
Taking the square root of equation 2.13, it is clear that the portfolio
standard deviation is linear in α. As the portfolio expected return is linear
in α, the locus of expected return–standard deviation combinations is a
straight line. This is shown in Figure 2.2.
Figure 2.2

If the correlation between returns is less than unity, however, the investor
can benefit from diversifying his portfolio. As previously discussed, in this
scenario, portfolio standard deviation is not a linear combination of σx
and σy. The reduction of portfolio risk through diversification will imply
that the mean–standard deviation frontier bows towards the y-axis. This
is also shown on Figure 2.2. The final curve on Figure 2.2 represents the
case where returns are perfectly negatively correlated. In this situation, a
portfolio can be constructed, which has zero standard deviation.

Activities
1. Assuming asset returns are perfectly negatively correlated, use equation 2.6
to find the portfolio weights that give a portfolio with zero standard deviation.
(Hint: write down 2.6 with the correlation set to minus one and a = α and
b = 1 – α. Then minimise portfolio variance with respect to α.)
2. Assume that the returns on Microsoft and Bethlehem Steel have correlation of
0.5. Using the data provided earlier in the chapter, construct the mean–variance
frontier for portfolios of these two assets. Start with a portfolio consisting only
of Microsoft stock and then increase the portfolio weight on Bethlehem Steel by
0.1 repeatedly, until the portfolio consists of Bethlehem Steel stock only.

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 Chapter 2: Risk and return: mean–variance analysis and the CAPM

From here on we will assume that return correlation is between plus and
minus one. The expected return–standard deviation locus for this case
is redrawn in Figure 2.3. In the absence of a risk-free asset, this locus is
named the mean–variance frontier. As our investor’s preferences are
increasing in expected return and decreasing in standard deviation, it is
clear that his or her optimal portfolio will always lie on the frontier and
to the right of the point labelled V. This point represents the minimum-
variance portfolio. He or she will always choose a frontier portfolio at or
to the right of V, as these portfolios maximise expected return for a given
portfolio standard deviation. In the absence of a risk-free asset, this set of
portfolios is called the efficient set.

Figure 2.3
We can now, given a set of preferences for the investor, find his or her
optimal portfolio. The condition characterising the optimum is that
an investor’s indifference curve must be tangent to the mean–variance
frontier.3 Two such optima are identified on Figure 2.3 at R and S. The 3
In technical terms the
investor locating at equilibrium point R is relatively risk-averse (i.e. his optimum is characterised
by the marginal rate of
or her indifference curves are quite steep), whereas the equilibrium at
substitution being equal
S is that for a less risk-averse individual (with correspondingly flatter to the marginal rate of
indifference curves). Figure 2.3 also shows sub-optimal indifference curves transformation (i.e. the
for each set of preferences. slope of the indifference
curve equals the slope of
the frontier).

Figure 2.4
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92 Corporate finance

Hence, as Figure 2.3 demonstrates, in a world of two risky assets and no

risk-free asset, the optimal portfolio of risky assets held by an investor
depends on his or her preferences towards risk and return. The same is
true when there are N risky assets available. Figure 2.4 depicts the same
type of diagram for the N asset case.
Note that the mean–variance frontier is of the same shape as that in
Figure 2.3. However, unlike the two-asset case, the interior of the frontier
now consists of feasible but inefficient portfolios (i.e. those that do not
maximise expected return for given portfolio risk). The mean–variance
frontier now consists of those portfolios that minimise risk for a given
expected return, whereas those portfolios on the efficient set (i.e. on the
frontier but to the right of V) additionally maximise expected return for a
given level of risk.
We now reintroduce a risk-free asset to the analysis (i.e. we assume the
existence of an asset with return rf and zero return–standard deviation).
A key question to address at this juncture is as follows. Assume that
we form a portfolio consisting of the risk-free asset and an arbitrary
combination of risky assets. How do the expected return and return–
standard deviation of this portfolio alter as we vary the weights on the
risk-free asset and the risky assets respectively?
Denote our arbitrary risky portfolio by P. We combine P with the risk-free
asset using weights 1 – a and a to form a new portfolio Q. The expected
return and variance of Q are given by:

E(RQ) = (1 – a)rf + aE(RP) = rf + a[E(RP) – rf ] (2.14)

σ2Q = a2σ2P . (2.15)

In order to analyse the variation in the risk and expected return of the
portfolio Q with respect to changes in the portfolio weights, we construct
the following expression:
dE(R Q) dE(R Q) /da
= . (2.16)
dσQ dσQ /da
Using equations 2.14 and 2.15 we find that:
dE(R Q) E(R p) – r f
= . (2.17)
dσQ σp
As this slope is independent of a, the risk–return profile of the portfolio Q
is linear. This is known as the capital market line, and two such CMLs are
shown in Figure 2.5 for two different portfolios of risky assets.
We now have all the components required to describe the optimal portfolio
choice of an investor faced with N risky assets and a risk-free investment.
Figure 2.6 replots the feasible set of risky asset portfolios. The key question
to answer is, what portfolio of risky assets should an investor hold? Using
the analysis from Figure 2.5, it is clear that the optimal choice of risky
asset portfolio is at K. Combining K with the risk-free asset places an
investor on a capital market line (labelled rfKZ), which dominates in utility
terms the CML generated by the choice of any other feasible portfolio of
risky assets.4 The optimal portfolio choice and a sub-optimal CML (labelled That is, choosing
4

portfolio K places an
CML2) are shown on Figure 2.6 along with the indifference curves of two
investor on a CML with
investors. greater expected returns
Recall that we previously defined the efficient set as the group of at each level of return
portfolios that both minimised risk for a given level of expected return and variance than does any
other.

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 Chapter 2: Risk and return: mean–variance analysis and the CAPM

maximised expected return for a given level of risk. With the introduction
of the risk-free asset, the efficient set is exactly the optimal CML.

Figure 2.5
The key result that is depicted in Figure 2.6 is known as two-fund
separation. Any risk-averse investor (regardless of his or her degree
of risk-aversion) can form his or her optimal portfolio by combining two
mutual funds. The first of these is the tangency portfolio of risky assets,
labelled K, and the second is the risk-free asset. All that the degree of risk-
aversion dictates is the portfolio weights placed on each of the two funds.
The investor with the optimum depicted at X on Figure 2.6, for example, is
relatively risk-averse and has placed positive portfolio weights on both the
risk-free asset and K. An investor locating at Y, however, is less risk-averse
and has sold the risk-free asset short in order to invest more in K.5 5
A short sale is the sale
of an asset that one
does not actually own.
One borrows the asset
in order to complete the
transactions and imme-
diately receives the sale
price. Subsequently, one
uses the proceeds from
the sale to repurchase
a unit of the asset, and
deliver it to the creditor.
If the price of the asset
has dropped in the
interim, one makes a
cash profit.

Figure 2.6
Two-fund separation is the result that underlies the capital asset pricing
model (CAPM), which is developed in the next section.

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92 Corporate finance

The capital asset pricing model

To begin our derivation of the CAPM, we present the assumptions that
underlie the analysis. These assumptions formalise those implicit in the
preceding section.
• Investors maximise utility defined over expected return and return
variance.
• Unlimited amounts may be borrowed or loaned at the risk-free rate.
• Investors have homogenous expectations regarding future asset returns.
• Asset markets are perfect and frictionless (e.g. no taxes on sales or
purchases, no transaction costs and no short sales restrictions).
We next need to extend slightly our analysis of the previous section in
order to derive the familiar form of the CAPM.

A mathematical characterisation of mean–variance optimisation

Consider Figure 2.6, which graphically identifies the optimal portfolio
of risky assets (K), held by an arbitrary risk-averse investor. The key
condition for optimality is that the capital market line and the mean–
variance frontier are tangent. The following equations give a mathematical
description of this optimality condition.
From equation 2.17, we know that the slope of the capital market line at
the optimum is:
E(R K) – r f
. (2.18)
σK
We also need the slope of the mean–variance frontier at the point of
tangency. To derive this, consider a position (called I) with portfolio
weight a in an arbitrary portfolio of risky assets (called j) and (1 – a) in the
optimal portfolio K. The expected return and standard deviation of this
position are:

E(RI) = aE(Rj) + (1 – a)E(RK) (2.19)

σ1 = [a2σ2j + (1 – a)2σ2K + 2a(1 – a)σjK]0.5. (2.20)

Using the same method as shown in equation 2.16 to derive the risk–
return trade-off at the point represented by portfolio I, we get:
dE(R 1)
= E(R j) – E(R K) . (2.21)
da

dσ 1
= 0.5[a 2σ j2+(1–a) 2σ K2+2a(1–a)σ jK] -0.5 (2aσ j2–2(1–a)σ K2+2(1–2a)σ jK).
da
(2.22)

The slope of the mean–variance frontier at K will be the ratio of 2.21 to

2.22 in the limit as a → 0. Note that equation 2.21 does not depend on a.
Taking the limit of equation 2.22 as a → 0 we get:

1 (σ – σ 2) . (2.23)
σ K jK K

The slope of the mean–variance frontier at K is the ratio of 2.21 to 2.23,

that is,
σK [E(R j ) – E(R K )]
. (2.24)
σJK – σK2

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 Chapter 2: Risk and return: mean–variance analysis and the CAPM

The optimum in Figure 2.6 equates the slope of the mean–variance

frontier at K with the slope of the CML. Hence, equating 2.18 and 2.24
and rearranging the resulting expression, we arrive at:
σjK
E(R j ) = r f + σ 2 [E(R K ) – r f ]. (2.25)
K

Defining βj = σjK / σ2K, equation 2.26 can be rewritten as:

E(Rj) = rj + βj[E(RK) – rf ]. (2.26)

Equation 2.26 is the standard β-representation of the mean–variance

optimisation problem. The equation translates as follows: the expected return
on a given asset (or portfolio of assets) is equal to the risk-free rate plus a
risk premium multiplied by the asset’s β.6 Assets that have large values of β 6
The risk premium is
will have large expected returns, whereas those with smaller values of β will defined as the excess of
the expected return on
have low expected returns with β defined as the ratio of the covariance of an
the tangency portfolio
asset’s returns with those on the market to the variance of the market return. over the risk-free rate.

Equilibrium and the CAPM

Equation 2.26 is simply derived from mean–variance analysis, and as
yet we have said nothing regarding equilibrium in asset markets. Capital
market equilibrium requires that the demand for risky securities be
identical to their supply. The supply of risky assets is summarised in the
market portfolio, which is defined below.

Definition
The market portfolio is the portfolio comprising all assets, where the
weights used in the construction of the portfolio are calculated as
the market capitalisation of each asset divided by the sum of market
capitalisations across all assets.

Two-fund separation gives us the fundamental result that all investors hold
efficient portfolios and, further, that all investors hold risky securities in the
same proportions (i.e. those proportions dictated by the tangency portfolio
(K)).7 For demand to be equal to supply in capital markets, it must be the case 7
All investors perceive
that the market portfolio is constructed with identical portfolio weights. The the same efficient set
and tangency portfolio
implication of this is simple: the market portfolio and the tangency portfolio
due to our assumption
are identical. This allows us to express the CAPM in the following form. that they have homo-
geneous expectations
The capital asset pricing model regarding asset returns.
Under the prior assumptions, the following relationship holds for all
expected portfolio returns:
E(Rj ) = Rf + βj [E(rM ) – rf ], (2.27)
where E(RM ) is the expected return on the market portfolio, and βj is the
covariance of the returns on asset j with those on the market divided by
the variance of the market return.
Equation 2.27 gives the equilibrium relationship between risk and return
under the CAPM assumptions. In the CAPM framework, the relevant
measure of an asset’s risk is its β, and 2.27 implies that expected returns
increase linearly with risk.
To clarify the source of the CAPM equation, note that the identification of
the tangency portfolio and the linear β-representation are implied by mean–
variance analysis. The CAPM then imposes equilibrium on capital markets
and identifies the market portfolio as identical to the tangency portfolio.

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92 Corporate finance

The security market line

Given equation 2.27, the equilibrium relationship between risk and return
has a very simple graphical depiction. In equilibrium expected returns are
linear in β. The expected return on an asset with a β of zero is rf , whereas
an asset with a β of unity has an expected return identical to that on the
market. Plotting this relationship, known as the security market line, we
get Figure 2.7.
Comparison of Figures 2.6 and 2.7 implies that, in equilibrium, two assets
with identical expected returns must have identical βs, although their return
variances can differ. The reason that their variances can differ is that a
proportion of asset return variance can be eliminated through diversification.
Agents should not be rewarded for bearing such risk, and hence, diversifiable
risk will not affect expected returns. Undiversifiable risk is that which is
driven by variation in the return on the market as a whole, and an asset’s
exposure to such risk is summarised by β. Hence an asset’s β measures its
relevant risk and, via equation 2.27, determines equilibrium expected returns.
The key message of the preceding paragraph is that β measures asset risk.
A high β asset is risky as it has high returns when market returns are high.
An asset with a low β tends to have high returns when market returns are
low. Hence a low β asset, when included in one’s portfolio, can provide
insurance against low market returns and hence is low risk.

Figure 2.7

Systematic and unsystematic risk

To mathematically illustrate the sources of asset risk we can use the CAPM
equation to decompose the variance of a given asset. Equation 2.27 gives
the equilibrium expected return for asset j. Actual returns on asset j will
follow a similar relationship but will also include a random error term.
Denoting this error by εj we have the following equation:
rj = rf + βj [rM – rf ] + εj. (2.28)
The variance of the risk-free return is zero by definition. Assuming that βj
is fixed we can represent the variance of asset j as:
σ2j = β2jσ2M + σ2ε. (2.29)

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 Chapter 2: Risk and return: mean–variance analysis and the CAPM

The final term on the right-hand side of equation 2.29 is the variance of
the error term and represents diversifiable risk. This source of risk is also
known as unsystematic and idiosyncratic risk. As emphasised previously,
this risk is unrelated to market fluctuations and, therefore, does not affect
expected returns. The first term on the right-hand side of 2.29 represents
undiversifiable risk, also known as systematic risk. This is risk that cannot
be escaped and hence increases equilibrium expected returns.

Activities8 8
You will find the
solutions to these
1. An investor forms a portfolio of two assets, X and Y. These assets have activities at the end of
expected returns of 9 per cent and 6 per cent and standard deviations of 0.8 this chapter.
and 0.6 respectively. Assuming that the investor places a portfolio weight of
0.5 on each asset, calculate the portfolio expected return and variance if the
correlation between returns on X and Y is unity.
2. Using the data from Question 1, recalculate the portfolio expected return and
variance, assuming that the correlation between returns is 0.5.
3. An investor forms a portfolio from two assets, P and Q, using portfolio weights
of one-third and two-thirds respectively. The expected returns on P and Q are
5 per cent and 7 per cent, and their respective return standard deviations are
0.4 and 0.5. Assuming the return correlation is zero, calculate the expected
return and variance of the investor’s portfolio.
4. Assuming identical data to that in Question 3, recalculate the statistical
properties of the portfolio, assuming the return correlation for P and Q is –0.5.

The Roll critique and empirical tests of the CAPM

The final topic we touch on in this chapter is the empirical validity of the
CAPM. The model of equilibrium expected returns that we have developed
in the preceding sections of this chapter is obviously not guaranteed to
hold in practice, and hence, rather than just blindly accepting its output,
we should examine how it holds up when applied to real data. However,
this task brings us face-to-face with a problem first pointed out by Richard
Roll and hence known as the Roll critique.9 9
See Roll (1977).

The statement of the CAPM is identical to the proposition that the market
portfolio is mean–variance efficient. Hence, Roll pointed out that empirical
tests of the CAPM should seek to examine whether this is indeed the case.
However, he also noted that the market portfolio (or the return on the
market) is not observable to an econometrician, who wishes to conduct a
test. Empirical researchers generally use a broad-based equity index such
as the FTSE-100, S&P-500 or Nikkei 250 to proxy the market. But the true
market portfolio will contain other financial assets (such as bonds and
stocks not included in such indices) as well as non-financial assets such as
real estate, durable goods and even human capital. Hence, the validity of
tests of the CAPM depend critically on the quality of the proxy used for the
market portfolio.
Based on the above, Roll’s critique is simply that, due to the fact that
the market portfolio is not observable, the CAPM is not testable. We can
understand this through the following arguments. First, it might be the
case that the market portfolio is efficient (and hence the CAPM is valid),
but our chosen proxy for the market is not efficient, and hence our
empirical test rejects the CAPM. Second, our proxy for the market might
be efficient whereas the market portfolio itself is not. In this case our test

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92 Corporate finance

will falsely indicate that the CAPM is valid. Put simply, the fact that we
can’t guarantee the quality of our proxy for the market implies that we
can’t place any faith in the results that tests based upon it generate, and
hence it’s impossible to test the CAPM.
The Roll critique is clearly damaging in that it implies that we can’t judge
the predictions of the CAPM against reality and trust the results. However,
many researchers have disregarded the prior discussion and estimated
the empirical counterpart of equation 2.27. From these estimates such
researchers pass judgment on the CAPM.
One prediction of the CAPM upon which some have focused is that the
expected excess return of a given portfolio over the risk-free rate (the risk
premium) is linearly related to β with the slope of this relationship given
by the market risk premium. Historically, however, when one plots actual
excess portfolio returns against their estimated βs one finds that the line
traced out is flatter than one would expect from the theory (i.e. low β
portfolios earn greater expected returns than the CAPM predicts, and high
β portfolios earn less). This is clearly evidence against the CAPM.10 10
See pp.185–86 of
Brealey and Myers
Another prediction of the CAPM, which is also empirically tested, is that (2008).
β is the only factor that should cause expected returns to differ (i.e. no
other variable should explain expected returns once we’ve accounted for
the effects of β). Again, the evidence from this line of attack is not good
for the CAPM. Among other factors, firm size, book-to-market ratios, P/E
ratios and dividend yields have all been shown to explain ex-post realised
returns (after accounting for β).
Amalgamating the above evidence implies that, if you are willing to
disregard the Roll critique, you should probably conclude that the CAPM
does not hold. This has led certain authors to investigate other asset-
pricing paradigms such as the APT (which we discuss in the next chapter).
An alternative viewpoint would be to argue that such results tell us little or
nothing about the validity of the CAPM due to the insight of Roll (1977).

A reminder of your learning outcomes

Having completed this chapter, and the essential reading and activities,
you should be able to:
• discuss concepts such as a portfolio’s expected return and variance as
well as the covariance and correlation between portfolios’ returns
• calculate portfolio expected return and variance from the expected
returns and return variances of constituent assets
• describe the effects of diversification on portfolio characteristics
• derive the CAPM using mean–variance analysis
• describe some theoretical and practical limitations of the CAPM.

Key terms
beta (β)
capital asset pricing model (CAPM)
correlation
covariance
diversification
expected return

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 Chapter 2: Risk and return: mean–variance analysis and the CAPM

market portfolio
mean–variance analysis
Roll critique
security market line
standard deviation
systematic risk
two-fund separation
unsystematic risk
variance

Sample examination questions

1. Detail the assumptions that underlie the CAPM and provide a
derivation of the CAPM equation. Support your derivation with
graphical evidence. (15%)
2. The returns on ABC stock and on the market portfolio in three
consecutive years are given in the following table:
Year ABC return Market return
1 8% 6%
2 24% 12%
3 28% 15%

Showing all your workings, compute the β for ABC’s equity. (7%)
3. Assume that the risk-free rate is 5 per cent. What is the expected return
on ABC’s stock? (3%)

Solutions to activities
1. The expected return on the equally weighted portfolio is 7.5%. The
portfolio return variance is 0.49, and hence the portfolio return
standard deviation is 0.7.
2. Obviously, the expected return is the same as in Question 1. With
correlation of 0.5, the portfolio return variance is 0.37.
3. The expected return on the portfolio is 6.33%, and the portfolio has a
return variance of 0.1289.
4. W
hen the correlation changes to –0.5, the portfolio return variance
drops to 0.0844. The expected return on the portfolio doesn’t change
from that calculated in Question 3.

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