Finance and Investment, BS00047

CAPM: Two Asset Example

Nick Webber
Nick Webber, Finance and Investment, 3b, CAPM, two assets 1
Example

Illustration of CAPM in a two-asset economy.

Given historical data:

Find the returns and standard deviations of portfolios in the economy.

Plot the data to get the ‘efficient frontier’.

Graphically estimate the returns to the market portfolio.

Calculate the betas of the assets.

Nick Webber, Finance and Investment, 3b, CAPM, two assets 2

Asset returns

Year-end prices for two assets:

Year Asset 1 Asset 2
1 128 87
2 149 116
3 153 157
4 105 164
5 133 129
6 193 138
7 156 187
With only these two assets in the economy, what is the market portfolio?
Procedure:
i) Calculate returns.
ii) Calculate a) expected returns 𝜇,
b) the covariance matrix, Σ.
iii) Calculate returns and standard deviations of portfolios 𝐹𝑝 .
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First Step

Calculate returns as (𝑆𝑡+1 − 𝑆𝑡 )⁄𝑆𝑡 .

𝑟1 𝑟2
0.164 0.333
0.026 0.353
-0.313 0.446
0.267 -0.213
0.451 0.070
-0.192 0.355
Average Returns:
To 𝐴1 , 𝜇1 = 0.067.
To 𝐴2 , 𝜇2 = 0.157.

Step (iia)
Set 𝜇 = (𝜇1 , 𝜇2 )′ = (0.067, 0.157)′ ,
Nick Webber, Finance and Investment, 3b, CAPM, two assets 4
Step (iib)

Calculate the covariance matrix, Σ. Obtain

0.068 −0.018
Σ=( ),
−0.018 0.044
so that, 𝜎1 = √0.068 = 0.261,
𝜎2 = √0.044 = 0.210.

(In this example have used population variance and covariance. ie

1 𝑛
𝜎 2 = ∑ (𝑟𝑖 − 𝑅 )2 ,
𝑛 𝑖=1
etc.)

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Third step:
Calculate returns and standard deviations of portfolios 𝐹𝑝

Proportion of wealth invested in 𝐴1 = 𝑝1 .

Write: 𝑝 = (𝑝1 , 1 − 𝑝1 )′ ,

Set:
𝐹𝑝 for the portfolio with proportions 𝑝,
𝜇𝑝 for the expected returns to 𝐹𝑝 ,
𝜎𝑝 for the standard deviation of returns to 𝐹𝑝 .

Recall:
𝜇𝑝 = 𝑝1 𝜇1 + (1 − 𝑝1 )𝜇2 .
𝜎𝑝2 = 𝑝12 𝜎12 + 2𝑝1 (1 − 𝑝1 )𝜎12 + (1 − 𝑝1 )2 𝜎22 .

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Portfolio expected returns and standard deviations:

𝑝1 𝜇𝑝 𝜎𝑝
-2 0.337 0.942
-1.5 0.292 0.751
-1 0.247 0.563
-0.5 0.202 0.379
0 0.157 0.211
0.5 0.112 0.139
1 0.067 0.262
1.5 0.022 0.438
2 -0.023 0.624
2.5 -0.068 0.813
3 -0.113 1.003

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Possible Portfolio Return-risk Combinations:
The Efficient Frontier.

The Riskless rate is 5.4%. Estimate from graph? 𝜇𝑀 =?, 𝜎𝑀 =?

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The Market Portfolio

The Market Portfolio has proportions 𝑝 = 𝑝𝑀 where

Σ−1 (𝜇−𝑟0 .1)
𝑝𝑀 =
1′ Σ−1 (𝜇−𝑟0 .1)
16.32 6.54
Σ −1 = ( )
6.54 25.14

Calculate:
16.32 6.54 0.013 0.890
Σ −1 (𝜇 − 𝑟0 . 1) = ( )( )=( ),
6.54 25.14 0.103 2.679
0.890
1′ Σ −1 (𝜇 − 𝑟0 . 1) = (1,1) ( ) = 3.569
2.679

Conclude 𝑝𝑀 = (0.249,0.751)′ .
′
Hence 𝜇𝑀 = 𝑝𝑀 𝜇 = 0.135,
′
𝜎𝑀 = √𝑝𝑀 Σ𝑝𝑀 = 0.150.

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Betas of the Assets
𝜎𝑗𝑀
To calculate 𝛽𝑖 = 2 first calculate the covariances 𝜎𝑖𝑀 .
𝜎𝑀

Have 𝜎𝑖𝑀 = 𝑝1 𝜎𝑖1 + (1 − 𝑝1 )𝜎𝑖2 .

𝜎1𝑀 0.004 𝛽1 1 𝜎1𝑀 0.164
So (𝜎 ) = ( ), and ( ) = 2 (𝜎 ) = ( ),
2𝑀 0.029 𝛽 2  2𝑀 1.278
M

Check, by substituting into CAPM:

𝜇𝑗 = 𝑟0 + 𝛽𝑗 (𝜇𝑀 − 𝑟0 ).

ie, verify that

0.067 = 0.054 + 0.164 × (0.135 − 0.054),
0.157 = 0.054 + 1.278𝑣(0.135 − 0.054).

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