The Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model, almost always referred to as the CAPM, is a
centerpiece of modern financial economics. Developed by William Sharpe1, John
Litner2, and Jan Mossin3, the CAPM provides a precise prediction on the relationship
between an asset’s risk and expected return. This is useful for two reasons. First, it
provides a benchmark rate of return for evaluating existing securities (i.e, looking for
overpriced/underpriced assets). Second, it allows us to make an educated guess as to the
initial price of a newly issued security.

Assumptions:

1) There are many small investors (“small” refers to their wealth relative to the
economy). No individual investor possesses enough wealth to influence the market.
(This is a standard “price taking” assumption present in most economic models).
2) All investors are myopic. (That is, investors have very short time horizons. Myopic
strategies are rarely optimal, but it’s a useful simplification).
3) Investments are limited to stocks, bonds, and a risk free asset (i.e. no derivatives)
4) No taxes, brokerage fees, etc (this assumption is not crucial….it simplifies the math a
little!)
5) All Investors are mean/variance optimizers (i.e, they choose their investments based
on the Markowitz portfolio model).
6) All investors have the same information and, hence, have the same estimates on
mean, variance, covariance, etc (this is known as homogeneous expectations).

Main Results

1) All investors will choose to hold the “market portfolio”. Further, the market portfolio
will be on the efficient frontier (the “letter C” from the Markowitz model) and will be
on the capital allocation line (the tangency to the efficient frontier). That is, the
“market portfolio” will be optimal.
2) The risk premium (the difference between the market return and the risk free return)
will be proportional to its risk (measures by variance) and the degree of risk aversion
in the economy. That is,
E (rm ) − r f = Aσ m2
3) The risk premium on individual assets will be proportional to the risk premium of the
market and the asset’s beta coefficient where Beta is given by
Cov(ri , rm )
βi =
σ m2
E (ri ) − rf = β i ((E (rm ) − rf )

1
William Sharpe, “Capital Asset Prices: A Theory of Market Equilibrium”, Journal of Finance, September
1964.
2
John Litner, “The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios
and Capital Budgets”, Review of Economics and Statristics, February 1965.
3
Jan Mossin, “Equilibrium in a Capital Asset Market”, Econometrica, October, 1966.
What is the “Market Portfolio” and why is it Optimal?

Technically speaking, the “market portfolio” is a portfolio containing every asset

available where the weight of each asset in the portfolio is equal to its market value
relative to the overall market. (That is, the “market portfolio” is a value weighted index
of the entire market). In practice, we can think of the market portfolio as any broadly
measured index (the bigger the better!). Something like the Russell 2000 or the Wilshire
500 would be great, but the Dow or S&P will work in a pinch!

How can we be sure that the market portfolio will be the optimal choice? The
mathematics behind this is a bit difficult, but the intuition is straightforward. In
equilibrium, all stocks must be held (ie, markets have to clear). Therefore, prices will
adjust to make sure that holding the market portfolio is the best choice. For example,
suppose that investors perceive GM as a risky investment and choose not to hold that
stock in their portfolio. With excess supply, GM stock will drop in price. How far will it
fall? It must fall to the point where the average investor is willing to hold it!

The Risk Premium on the Market Portfolio

Recall the intuition behind the Markowitz portfolio. Investors were choosing the
allocation of assets in their portfolios to maximize the ratio of risk to reward. This is
represented graphically as follows.

The capital allocation line (CAL) represents all the possible allocations between the risk
free asset and the optimal risky portfolio (represented by point A). From now on, we will
refer to the optimal risky portfolio as the market portfolio. To choose the optimal choice
on the capital asset line, investors use the following criteria:

[
Max E (r ) − 2 Aσ 2 ] (*)

‘A’ is the investor’s “risk aversion”. The larger value ‘A’ takes on, the more the investor
penalizes risk in a portfolio. Recall that if we allocate a fraction ‘y’ of the investor’s
wealth in the market portfolio and the remaining (1-y) in the risk free asset. The
combined expected return and variance will be:
 E (r ) = yrm + (1 − y )r f = r f + y (rm − r f )
σ 2 = y 2σ m2

This boils down to a standard calculus problem: maximize the starred expression by
choice of ‘y’. The solution to this problem is

rm − r f
y* =
Aσ m2

Now, what must the value of y be in equilibrium? Risk free bonds are in zero net supply.
Therefore, y must be 1 in equilibrium (ie, nobody holds risk free bonds in equilibrium).
This implies that

rm − r f
1=
Aσ m2
rm − r f = Aσ m2

This proves the second result.

Pricing individual assets – the beta coefficient

Here’s where it gets tricky. To solve this, always remember that the market
portfolio is the optimal strategy. Therefore, there exists no alternate investment strategy
that will be superior in terms of risk versus return.

Assume that we are holding the market portfolio. How would our risk and return be
affected if you deviated slightly. For example, suppose that you borrow a small amount
‘d’ at the risk free rate and use those funds to purchase a small amount of the market
portfolio. Your additional return would be

∆E (r ) = d (rm − r f )

This investment shift would also affect your portfolio variance. The additional variance
is given by

∆σ 2 = (1 + d ) σ m2 − σ m2 = (1 + 2d + d 2 )σ m2 − σ m2
2

We are only considering very small portfolio adjustments. Therefore, ‘d’ is a small
number. For simplicity, we can assume that the squared term is small enough to ignore.
Therefore, the above expression simplifies to

∆σ 2 = 2dσ m2
Therefore, the change in risk/return due to the small deviation is

∆E (r ) rm − r f
=
∆σ 2 2σ m2

Now, suppose that we start once again at the market portfolio. This time, deviate from the
market portfolio by borrowing a little at the risk free rate and investing in, say, GM,
stock. Again, the change in your portfolio return would be

∆E (r ) = d (rGM − r f )

The change in your portfolio variance would be4

∆σ 2 = d 2σ GM
2
− 2 cov(rGM , rm )

Again, because d is a small number, we can neglect the squared term. Therefore, the
change in risk/reward by this portfolio shift is

∆E (r ) rGM − r f
=
∆σ 2 2 cov(rGM , rm )

The last step is to recognize that each strategy should have identical effects in terms of
risk and reward. Otherwise, there would be a way of exploiting the discrepancy (for
example, shorting the market portfolio and buying GM). Therefore, it must be the case
that
rGM − r f rm − r f
=
2 cov(rGM , rm ) 2σ m2

Rearranging the above expression gives us the final result.

 cov(rGM , rm ) 
` rGM − rm =  (rm − r f ) = β GM (rm − r f )
 σ 2
m 

4
This calculation is a little tricky!