Fall 2019 Corporate Finance, Lecture 4 1

The Capital Asset

Pricing Model (CAPM)

Professor Siyi Shen

 Fall 2019 Corporate Finance, Lecture 4 2

Sharpe on CAPM
 William Sharpe, one of the originators of the CAPM, in an
interview with the Dow Jones Asset Manager:

 “…But the fundamental idea remains that there’s no reason to

expect reward just for bearing risk. Otherwise, you’d make a lot of
money in Las Vegas. If there’s reward for risk, it’s got to be
special…

 There’s got to be some economics behind it or else the world is a

very crazy place. I don’t think differently about those basic ideas at
all”. Sharpe (1998)
 Fall 2019 Corporate Finance, Lecture 4 3

Introduction to CAPM
 How do we identify the tangency portfolio?

 Is it different for different investors?

Must be the same if investors agree on the measure of an asset’s
relevant risk.

 CAPM provides assumptions under which all investors do agree on

the benchmark (tangency) portfolio—this is referred to as the
“market” portfolio, M.

 An asset’s relevant risk is the portion of its risk which cannot be

diversified away by including it as an element of M.
 Fall 2019 Corporate Finance, Lecture 4 4

Composition of M: Equilibrium
 Under financial market equilibrium, the supply and demand of
risky assets must equal at the prevailing prices.

 Thus, what investors want to hold, M, must equal what they

actually do hold: Market portfolio contains all risky assets and the
proportion of each asset is its market value as a percentage of total
market value. The weight on asset i in the market portfolio is
given by

Total market value of asset i

wi =
Total market value of all risky assets
 Fall 2019 Corporate Finance, Lecture 4 5

CAPM Assumptions
 Mean-variance criterion: Investors care about risk and return only
in terms of mean and variance.
 Homogeneous expectations: Same information about the
distribution of an asset’s returns, and process the information in the
same manner.
 Competition: Security markets are competitive and investors are
price takers.
 Investors can borrow or lend freely at the risk-free rate.
 Single-period investment horizon.
 Transactions costs: No taxes and transactions costs.
 Fall 2019 Corporate Finance, Lecture 4 6

CAPM Assumptions – Cont’d

 These assumptions are clearly not satisfied in reality:
Any model is an approximation of reality.

 Results based on CAPM must necessarily be viewed as

approximations.
 Fall 2019 Corporate Finance, Lecture 4 7

Capital Market Line (CML)

 Same efficient frontier of for all investors—Investors differ only
in the proportion of their wealth invested in the risk-free asset
versus M.

 E (rM ) − rf 
E (rp ) = rf +  σ p
 σM 
 CML describes the relationship between risk and return only for
efficient portfolios
 If an investor were to hold a portfolio not lying on the CML, s/he
would be bearing unnecessary excess risk: no finance student
would hold such a portfolio.
 Fall 2019 Corporate Finance, Lecture 4 8

Characterizing the Market Portfolio

 Since every risky asset is in M, all of M’s risk (that is, σM) is, by
construction, systematic: No more opportunities for diversification.

 Let’s derive a general formulation for the variance of a portfolio of

N risky assets:
 N

( )
σ p = cov R p , R p = cov ∑ wi Ri , R p 
2

 i =1 
N N
= ∑ wi cov(Ri , R p ) = ∑ wi ρ ipσ iσ p
i =1 i =1
 Thus,
N
σ p = ∑ wi ρ ipσ i
i =1
 Fall 2019 Corporate Finance, Lecture 4 9

Characterizing the Market Portfolio –

Cont’d
 Thus we can write σM as:
N
σ M = ∑ wi ρ iM σ i
i =1
I.e., σM can be thought of as the sum of the risk contributions of its
constituent assets.

 Note that an asset i’s total risk can be decomposed into two parts:

σ i = ρ iM σ i + (1 − ρ iM )σ i

where ρiMσi is the systematic component and (1 – ρiM )σi is the

unsystematic or diversifiable component.
 Fall 2019 Corporate Finance, Lecture 4 10

CAPM: A Simple Derivation

 Suppose we change holding of asset i a little bit:

N
σ M = ∑ wi ρ iM σ i
i =1
N
E (rM ) = ∑ wi E (ri )
i =1

 In equilibrium, the following must hold for any asset i and j:

E (ri ) − rf E (rj ) − rf E (rM ) − rf

= =
ρ iM σ i ρ jM σ j σM
 Fall 2019 Corporate Finance, Lecture 4 11

CAPM: A Simple Derivation– Cont’d

 Rearranging the above equation:

 E (rM ) − r f 
E (ri ) = r f + ρ iM σ i  
 σ M 
ρ iM σ iσ M
⇒ E (ri ) = r f +
σM2
[E (rM ) − rf ]

cov(ri , rM )
⇒ E (ri ) = rf +
σ 2
[E (r ) − r ]
M f
M

⇒ E (ri ) = rf + β [E (r ) − r ]
i M f
 Fall 2019 Corporate Finance, Lecture 4 12

The Security Market Line (SML)

 The CAPM decomposes the expected return on a risky asset into three
components:
[
E (ri ) = rf + β i E (rM ) − rf ]
risk-free rate, market risk premium, and the asset’s beta.

 Market risk premium 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: The higher the asset’s beta, the higher is its expected
return.
 Fall 2019 Corporate Finance, Lecture 4 13

The Security Market Line (SML) –

Cont’d
 Differences in expected returns among risky assets are due to the
differences in their betas.

 The relationship between expected return and beta is illustrated on

the Security Market Line (SML).
 Fall 2019 Corporate Finance, Lecture 4 14

Mispricing Relative to CAPM

 Consider the following example:

E(rM) = 8%, σM = 16%, rf = 3%

 and suppose that a security with a beta of 2 is offering expected return

of 15%. Is this security under/over priced?
 Fall 2019 Corporate Finance, Lecture 4 15

CML and SML

 CML describes the equilibrium relationship between the systematic
risk and expected return only for efficient portfolios:

 E (rM ) − rf 
E (rp ) = rf +  σ p
 σM 

 SML describes the equilibrium relationship between the systematic

risk of any asset or portfolio (as measured by beta) and its expected
return:
[
E (ri ) = rf + β i E (rM ) − rf ]
Fall 2019 Corporate Finance, Lecture 4 16

CAPM Applications

Professor Siyi Shen

 Fall 2019 Corporate Finance, Lecture 4 17

Regression Analysis
Ordinary Least Squares
 The CAPM is a theory of asset pricing that predicts a simple, linear
relation between the expected excess return of any asset and the
market portfolio:

( )
E ri = β i E r
e
( )e
M

where
e
ri = ri − rf

and
βi =
(
cov rie , rMe )
σ M2
 Fall 2019 Corporate Finance, Lecture 4 18

Ordinary Least Squares – Cont’d

 Notice that the CAPM describes the relation between the expected
asset returns and expected market portfolio returns. However, we
do not observe expected returns, and furthermore, the true market
portfolio is not observable either.

 Thus, we use data on the past realized returns and a proxy for the
true market portfolio for estimation of beta.

 Suppose we have the past return data on some asset i and a market
portfolio proxy (a broad market index such as S&P500).
 Fall 2019 Corporate Finance, Lecture 4 19

Ordinary Least Squares – Cont’d

 We can use a linear regression, in particular, Ordinary Least Square
(OLS) regression, to estimate the beta of asset i using this data. A
linear regression equation describes the relationship between the
excess return on asset i and the excess return on the market
portfolio proxy by a straight line as follows:

r = αi + β r
e
i ,t
e
i M ,t + ei ,t t = 1,2,..., T
where αi is the intercept and βi is the slope of the straight line. ei,t is
the residual term, and assumed to be uncorrelated with the
independent variable, and E[ei,t] = 0. OLS is simply choosing αi
and βi so as to minimize the sum of the squared residual terms:
T

∑e
t =1
2
i ,t
 Fall 2019 Corporate Finance, Lecture 4 20

Estimating Beta with OLS

 The choices of the intercept and slope that minimize the sum of the
squared residuals are called OLS regression coefficients. Consider
a general case of OLS regression, where the dependent variable is y,
and the independent variable is x:
y=a+bx+e
The OLS regression slope coefficient is given by bˆ =
cov y, x ( )
σ x2
 In the context of our example, rie = α i + β i rMe + ei

The OLS regression slope coefficient is given by ˆ

βi =
(
cov ri , r e e
M )
var rMe ( )
 Notice that this is the same as the beta defined in the CAPM. We
can therefore use OLS to estimate beta.
 Fall 2019 Corporate Finance, Lecture 4 21

Variance Decomposition
 Consider the variance of the left- and right-hand side of our
regression equation:
σ i2 = Var (α i + β i rMe + ei )

σ i2 = β i2Var (rMe ) + Var (ei )

Thus, the total variance of asset i can be decomposed into the
systematic variance and idiosyncratic/firm-specific variance.

 The R2 statistic is a measure of the explanatory power of the

regression.
2 β i2Var (rMe ) β i2Var (rMe ) Systematic risk of asset i
R = 2 = =
β i Var (rM ) + Var (ei )
e
σi2
Total risk of asset i