Part 2.

2
Risk: Capital Asset Pricing Model (CAPM)

CORPORATE FINANCE (PSBV026NABB)

Nóra Felföldi-Szűcs, PhD

Department of Finance, Corvinus
University of Budapest
2021 FALL
 FNÁ1

Topics Today
• Recap
• Capital Asset Pricing Model Assumptions
• Beta and the Security Market Line
• Components of Risk
• Risk in Practice

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Frontier portfolios I.
Possible portfolios in case of many assets
Minimal standard deviation at a certain level of return.
If only risky assets are in the portfolio:

49

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Both risk-free and risky asset in portfolio
60%

50%

40%

30%

20%

10%

0%
0% 10% 20% 30% 40% 50% 60%

-10%

-20%

efficient frontier CAL

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 CAL with a fixed rf
For any given portfolio “P” consisting of a risk-free asset “F” and risky asset(s) “N”:
• The expected return, E(rP) = wF rF + (1- wF) rN
• The variance of returns, σP² = ΣF ΣN wF wN Cov (rF ,rN)
• The volatility (SD) of returns, σP = wN σ N since Cov (rF ,rN) = 0

E(r)
CAL

rF
F

σ
Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD
 CAL – Capital Allocation Line
Investors

U3
E(r) U2
U1 CAL

rF
F

σ
Preferences of investor

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 8 November 2021

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Interpreting utility indifference lines

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 8 November 2021

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Interpreting utility indifference lines

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Portfolio Decision-making Model (Markowitz)
1. Determine the possible risk-return combinations

2. Determine the portfolio with minimal standard deviation – frontier portfolios

3. The optimal combination of risky assets – the steepest CAL

4. Determine the whole portfolio by combining the risk-free asset with the optimally-weighted
risky sub-portfolio – moving on the steepest CAL

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Capital Asset Pricing Model (CAPM)
• The application of Markowitz’s MPT is difficult in practice:
• The estimation of covariance is different for different investors,
• they have access to different securities, and
• their time horizons are not the same
• Investors have different expectations
Þ CAL is not unique
• Investors with different expectations choose from different CALs
• Questions
• What can be learnt by aggregating all investors’ decisions?
• And under what assumption could an equilibrium evolve?

William F. Sharpe (1964, Nobel-prize 1990)

Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.
.

Under CAPM all investors have efficient portfolios with the same risky part ’
Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD
 CAPM Assumptions in detail -- memorize
Perfect capital markets
• No taxes, and no transaction costs
• Individual investors are price takers
• Information is costless and available to all investors

Behaviour of investors
• Single-period investment horizon
• Investors are rational mean-variance optimizers according to MPT
• Homogeneous expectations

Set of investment opportunities

• Investments are limited to traded financial assets
• Short selling is possible
• Risk free interest rate for loans and deposits where rf is fixed

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Resulting Equilibrium Conditions under CAPM
• All investors will hold the same portfolio for risky assets Þ market portfolio

• Market portfolio contains all securities and the proportion of each security is its market value as a
percentage of total market value

• 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

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 CML – Capital Market Line
• The CML is a CAL defined by a risk-free asset “F” and the Market Portfolio “M”

• CML returns contain the Risk Premium for all efficient portfolios as a linear function of the
standard deviation of expected return.

E(r)
CML

rM M
rF E(rM) – rF , Market Risk Premium
F

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Beta (β) – the concept
If I change the portfolio weight of a given security in a diversified portfolio, how does this change
the risk of my whole portfolio?

• Whilst the market risk premium can be related to the risk aversion of the market participants,
an asset’s risk premium depends on its riskiness relative to that of the market

• We assume the asset’s risk premium is linearly related to the market risk premium

• We define an asset’s Beta (β) as how much higher / lower risk relative to the market portfolio
that asset adds to a diversified portfolio

Beta solves the equa,on for a given asset: ri = rf + βi (rm – rf)

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD
 Beta (β) – calculation and meaning
• Beta is thus calculated as the Regression Coefficient of an asset with the market

Cov (rN, rM)

e.g. for asset N: Beta, βN =
VarM
σN
(similar to, a “directional” form of, the Correlation Coefficient: β = ρ x )
σM
• In return terms,
• Beta shows the sensitivity of a stock’s return to the market portfolio’s return. (how much it has / is expected to
change for a 1% movement up/down of the entire market)

• In risk terms,
• Beta is a measure of the Market Risk of a security
• The risk of a single security is measured by beta (vs. risk of a portfolio is measured by standard deviation)

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 SML – Security Market Line
• The Security Market Line (SML) shows the returns of every risky asset “N” as a function of its
Beta, its market risk
apparently
E(r) underpriced
assets SML

rM N
rF apparently
F overpriced
assets

β=1 β

• The SML can be used for both securities & portfolios

The Security Market Line (SML) is defined by ri = rf + β11i (rm – rf)

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD
 Equilibrium State
1. Every investor will split the money between risk-free investment and the market portfolio “M”

2. The steepest CAL is called CML, is tangential to the Efficient Frontier and meets it at the
market portfolio “M”

3. M’s risk premium is proportional to the its risk and to the risk aversion of the typical investor

4. The risk premium of any given N security is proportional to M market risk premium and the
beta coefficient, where βN = Cov(rN, rM) / σ²M

CAPM Message #1: Passive strategy is efficient, the optimum on CML

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD
 The novelty in CAPM
Before CAPM:
• Investment decisions made based on the expected return and the σ standard deviation risk
measure

Result of CAPM:

• Only part of the σ is relevant, that relating to the co-movements with the market i.e. market /
systematic risk! This part of the total σ risk is measured by beta

• Investors need not consider the part of the risk which is not correlated with market movements

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Measuring Risk
Total Risk
• The sum of Market Risk and Unique Risk
• Measured by total variance, σi2

Portfolio standard deviation

Market Risk or “systematic risk”
• Resulting from economic factors that affect the overall stock market
• Measured by systematic variance, βi2 σm2
Unique
risk

Unique Risk,“unsystematic risk”, “Diversifiable risk” or “Residual Risk” Market risk

• Resulting from Risk factors affecting only that firm 0
5 10 15
• Measured by unsystematic variance, σei2 Number of Securities

Total Risk σi2 = βi2 σm2 + σei2 17

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 Alpha
• An asset N’s Alpha is the historic excess / deficient return w.r.t. the SML

E(r) N
SML
α
rM
rF
F

β=1 β

• Alpha results from the model: ri = rf + βi (rm – rf) + α

Alpha derives from Residual Risk

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD
 8 November 2021

Citibank, the Financial Sector & the US Market r

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 8 November 2021

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Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 8 November 2021

Computing Beta, ex Post Header

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 8 November 2021

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Betas vary over time – a lot

Sectors are more stable than stocks

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD
 8 November 2021

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Equity Sector Betas

• Vary from 0.2 to 3 in practice

• Check out Damodoran’s data at NYU for more detail

Corporate Finance, CUB - Nóra, Felföldi-Szűcs, PhD

 8 November 2021

Thank you
for your attention!