CHAPTER 3 Capital Asset Pricing Model Capital Asset Pricing Model (CAPM) is a simple model that explains the risk-reward relationship for any individual asset or portfolio of assets. The model was originally developed independently by Treynor (1961) and Sharpe (1964). Then, it was further extended and clarified by Lintner (1965). The CAPM is considered an equilibrium theory of price formation in financial markets. The equilibrium that we are referring to here is the financial equilibrium in capital markets where the demand for financial assets (or securities) is equal to the supply. In fact, CAPM assumes that all asset prices clear the markets of all assets. The CAPM model, unfortunately, does not explain or derive this financial equilibrium: rather it assumes that it is the result of market efficiency. This hypothesis is known as the efficient markets hypothesis (EMH), which was formalized in (1970) by Eugene Fama, The axiom posits that capital markets are ideal in the sense that, at any point in time, security prices in any market fully reflect all available information in that particular market. call, from Chapter 1, that capital markets allocate ownership of the econ- 1y’s capital stock. The participants in the capital markets are firms and Wvestors. Firms are after making production-investment decisions whereas wwestors are after making consumption-investment decisions. In order to raise capital, firms borrow by issuing securities that represent the firms’ ac- tivities in the capital market. The money raised from issuing these financial securities are used in production. Investors, on the other hand, are engaged in making investment decisions by choosing among the available securities in the market, ie., lending the corresponding issuing firms, in order to smooth their consumption. Like any other market, the outcome of capital market, is the market price of each traded security. Since the quantities traded are fixed, i.e., the supply is fixed, fluctuations in the demand side is what causes the prices of securities to vary. If security prices at any time fully reflect all available market information, the market is said to be an efficient market. DEFINITION 25. The efficient markets hypothesis (EMH) posits that at any point in time, security prices fully reflect all market information. In other words, market participants have perfect information regarding the financial assets traded in the market at any point in time. 53 Scanned with CamScannerA 3. CAPITAL ASSET PRICING MODEL The EMH implies that all market participants have the same information about all the securities traded in the market. In other words no participant has any information advantage over another. Under this perfect informa. tion assumption, it is likely that all market participants will have the same expectations about the risks and the returns of the financial assets that are traded in the market, and consequently all market participants should make the same decisions. This, in turn, rules out any opportunities to exploit profit. To see how a profit opportunity might arise in a financial market, consider, for instance, the case where an investor expects that the price of an asset will increase in the future, i.e., the current asset price is under-priced. If this investor formed his/her expectations based on information that was not available to all market participants, then, to make profit, this investor ought to buy the asset now and wait to sell it in the future at a higher price. Such profit opportunities, which arise when asset prices are under or over priced, are ruled out when markets are assumed to be efficient. In other words, if there is a possibility of making profit in the market, then this market is said to be inefficient. In finance, in general, there are two schools of thought: one believe in the EMH and the other doesn’t. The proponents of market inefficiencies, or the so-called behavioral finance school, argue that asset prices could be under or over priced as a result of many factors. One factor could be the existence of information advantages that some market participants might have over others. Another factor has to do with the fact that investors overreact to financial news, which, in turn, causes market fluctuations based on irrational expectations. Empirical evidence from behavioral finance and neuroscience shows that capital markets are not efficient all the time; they behave in an efficient way sometimes but they surely exhibit periods of irrational behavior due to the overreaction of market participants (especially retail traders) to various news and/or predictions of shocks. At any rate, there is evidence to support both schools; financial markets are efficient sometimes and inefficient some other times. It is worth noting though that CAPM, as a model of price formation, is built on the premise of market efficiency. The analytical result of the model, which we will discuss shortly; is derived under the EMH. Although that might not be necessarily the case in practice, still the model is useful in giving investors the ideal risk-reward relation of a financial asset or a portfolio of assets, This relation could be taken as the benchmark against which inefficiency can be measured and quantified. We will discuss how this can be achieved shortly. As for now, we begin by discussing the key axioms based on which the CAPM is built. Scanned with CamScanner1. THE AXIOMS OF CAPM 85 1. The Axioms of CAPM ‘The CAPM model of Shar Seamaticit, pe (1964) and Lintner (1965) is built on 4 key AXIOM 1. Risk Attitude Axiom: Investors are risk-averse AXIOM 2. (Er - o) Axiom: Investors ¢: are only dard deviation of only about the mean and stan- their one period investment return. AXIOM 3. Perfect Information. Investors timely receive all relevant in- formation pertaining to their investment deci z lecisions, and have complete agree- ment about the future distributions of asset returns. ia AXIOM 4. No transaction costs, AXIOM 5. Equilibrium Axiom: Borrowing and lending are done at the risk-free rate, which is the same for all investors and does not depend on the amount borrowed or lent. Axiom 1 is sensible; most investors in financial markets are risk-averse in- vestors who are willing to take risk, c, only if there is a possibility of higher returns, ie., only when there is high Er. Axiom 2 stems from 1. A risk- averse investor cares only about the mean, i.e., expected return, and stan- dard deviation i.e., risk, of return, . Axiom 3 is about perfect information. All investors have complete agree- ment about the distributions of returns, ic., all investors have complete agreement about the future states of the economy and the corresponding price probabilities of the traded assets. This means that investors will have the same expectations regarding the rates of returns on the traded assets. In other words, this axiom ensures that markets are efficient. It is simply one way of stating the EMH. The reason it is stated as a complete agreement of distribution of returns, rather than just saying that financial markets are efficient, is because when CAPM was proposed in 1964 and 1965 the EMH has not been formalized yet. It was Fama (1970) who proposed the EMH in 1970. ‘Axiom 4 assumes that investors can borrow or lend in the financial market at no cost. This assumption is imposed to simplify the model by ruling out broker fees and any other costs associated with financial transactions. This assumption is imposed for simplicity and doesn’t affect the validity of the model. Finally, Axiom 5 ensures that the market is at equilibrium by equating the borrowing and lending. When we assume that investors can borrow and lend at the same risk-free rate, then we are creating a market mechanism in which Scanned with CamScanner= 3. CAPITAL ASSET PRICING MODEL investors construet portfolios by mixing the risk-free asset with the market or any other combinations of assets traded in the market. The market portfolio, which we will denote by M, is the value-weighted portfolio of al) traded assets. The weight of every risky asset # wi, in the market portfolio si market value of all outstanding units of the asset total market value of all risky assets ‘Thus, when we assume that borrowing and lending are done via a risk-free asset, then investors are assumed to construct portfolios such that a portion of their wealth is invested in the risk-free asset and the remainder in the market (or any other portfolio of assets). Here is an example to illustrate this point. EXAMPLE 15. Consider a market of assets, ¢.g., the Dow Jones Industrial ‘Average (DJIA). The DJIA index itself is the market portfolio, which is de- noted by M. Let rar be the rate of return on the market portfolio. Consider a risk-free asset, e.g., a government bond. Let rf be the risk-free rate. If bor- rowing and lending are allowed via the risk-free rate, then it is that rate that allows the trading. Basically, it is a way of mimicking a financial market, Investors can mix the risk-free with the market to construct a portfolio by either borrowing or lending via the risk-free rate. To see this, suppose you have a $1000 and you want to construct a portfolio by mixing the risk-free asset with the market portfolio. You can invest $600 of your wealth in the risk-free asset; that is, the weight of the risk-free asset in your portfolio is ‘wr = $2, = 0.66. The remainder 40% is allocated on the market portfolio; that is, the weight of the market portfolio is war = 7%; = 0.4. Let p be the constructed portfolio. Then, from equation (2.16), the rate of return on portfolio p is te = wyrf tute (0.6)rf + (0.4)ras- This is how a portfolio that mixes the risk-free asset with the market is constructed. To see how lending and borrowing could be done via the risk- free rate, consider the case of an aggressive investor, with an initial level of wealth $1000, who wishes to invest 150% of his wealth in the market portfolio, i.c., wx = 1.5. To this end, the investor needs to borrow $500 (50% of his wealth) at the risk-free asset and invest the amount borrowed plus all his wealth in the market portfolio. Thus, the weight of rf in this case is wys = —0.5. Notice that the weight of the risk-free asset is negative since the investor is borrowing. Notice also that the sum of both weights should always add to one. Thus, in this case, Te = wrt f + wre = (-0.5)rf + (L.5)rar. Scanned with CamScanner