Capital Market Theory

Investment Analysis & Portfolio Management Asset Pricing Principles
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CAPITAL MARKET THEORY

Capital Market Theory is the theory developed in the 1960s and made popular by William Sharpe. It
piggybacked on Modern Portfolio Theory but added a risk-free asset to portfolio mix. This allowed investors to
build portfolios with two components: the risk-free asset, like Treasury Bills, and a Market portfolio which
maximizes the return-over-risk ratio of all risky assets. This changed portfolio choice from the efficient frontier
to the straight line from the risk-free rate to the Market portfolio, and the concept of multi-asset-class
allocation was born.
DEFINITION:
Capital market theory extends portfolio theory and develops a model for pricing all risky assets.
Capital Market Theory tries to explain the movement of the Capital Markets over time using one of the many
mathematical models. The most commonly used model in the Capital Market Theory is the Capital Asset
Pricing Model.
CAPITAL ASSET PRICING MODEL (CAPM):
The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between the expected
return and systematic risk of investing in a security. It shows that the expected return on a security is equal to
the risk-free return plus a risk premium, which is based on the beta of that security.
Capital asset pricing model (CAPM) will allow us to determine the required rate of return for any risky asset.
Capital asset pricing model starts with the idea that individual investment contains two types of risk:
Systematic Risk – These are market risks—that is, general danger of investing—that cannot be diversified
away. Interest rates, recessions, and wars are examples of systematic risks.
Unsystematic Risk – Also known as "specific risk," this risk relates to individual stocks. In more technical terms,
it represents the component of a stock's return that is not correlated with general market moves.
Modern portfolio theory shows that specific risk can be removed or at least mitigated
through diversification of a portfolio. The trouble is that diversification still does not solve the problem of
systematic risk; even a portfolio holding all the shares in the stock market can't eliminate that risk. Therefore,
when calculating a deserved return, systematic risk is what most trouble for investors. CAPM evolved as a way
to measure this systematic risk.
ASSUMPTIONS OF CAPITAL ASSET PRICING MODEL/CAPITAL MARKET THEORY:
Following are the assumptions of capital asset pricing model.
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1. All investors are Markowitz efficient investors who want to target points on the efficient frontier.
2. Investor can lend or borrow any amount of money at the risk free rate of return(RFR)
3. All investors have homogeneous expectations; that they estimate identical probability distributions for
future rates of return.
4. All investors have the same one period time horizon such as one month, six months, or one year.
5. All investments are infinitely divisible, which means that it is possible to buy and sell fractional shares of
any asset or portfolio.
6. There are no taxes or transaction costs involved in buying and selling assets.
7. There is no inflation or any change in interest rates.
8. Capital markets are in equilibrium. This means that we begin with all investments properly priced in line
with their risk level.
Capital Asset Pricing Model (CAPM) Formula:
The formula for calculating the expected return of an asset given its risk is as follows:
ERi = Rf+ (ERm−Rf) βi

Where
ERi=expected return of investment
Rf=risk-free rate
βi=beta of the investment
(ERm−Rf) =market risk premium
The beta of a potential investment is a measure of how much risk the investment will add to a portfolio that
looks like the market. If a stock is riskier than the market, it will have a beta greater than one. If a stock has a
beta of less than one, the formula assumes it will reduce the risk of a portfolio.
A stock’s beta is then multiplied by the market risk premium, which is the return expected from the market
above the risk-free rate. The risk-free rate is then added to the product of the stock’s beta and the market risk
premium. The result should give an investor the required return or discount rate they can use to find the value
of an asset.
Assume the following for Asset XYZ:

Rf = 3%
Rm = 10%
βa = 0.75
By using CAPM, we calculate that you should demand the following rate of return to invest in Asset XYZ: ERa
= 0.03 + [(0.10 - 0.03) * 0.75] = 0.0825 = 8.25%
SECURITY MARKET LINE (SML):
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When the expected rate of return as per CAPM is presented graphically, it will be a straight line sloping
upward such line is known as security market line (SML).
Also known as the "characteristic line," the SML is a visualization of the CAPM, where the x-axis of the chart
represents risk (in terms of beta), and the y-axis of the chart represents expected return. The market risk
premium of a given security is determined by where it is plotted on the chart relative to the SML.
SML slopping upward indicates that the higher the beta the higher the expected return.
Determining the Expected Rate of Return for a Risky Asset:
To demonstrate how you would compute expected or required rates of return with the CAPM, consider the
following example stocks, assuming you have already computed betas:
Assume that we expect the economy’s RFR to be 5 percent (0.05) and the expected return on the market
portfolio (E(RM)) to be 9 percent (0.09). This implies a market risk premium of 4 percent (0.04). With these
inputs, the SML would yield the following required rates of return for these five stocks:
Stock A has lower risk than the aggregate market, so you should
not expect its return to be as high as the return on the market portfolio. You should expect Stock A to return
7.80 percent. Stock B has systematic risk equal to the market’s (beta = 1.00), so its required rate of return
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should likewise be equal to the expected market return (9 percent). Stocks C and D have systematic risk
greater than the market’s, so they should provide returns consistent with their risk. Finally, Stock E has a
negative beta (which is quite rare in practice), so it’s required rate of return, if such a stock could be found,
would be below the RFR of 5 percent.
In equilibrium, all assets and all portfolios of assets should plot on the SML. That is, all assets should be priced
so that their estimated rates of return, which are the actual holding period rates of return that you anticipate,
are consistent with their levels of systematic risk. Any security with an estimated rate of return that plots
above the SML would be considered undervalued because it implies that you forecast receiving a rate of
return on the security that is above its required rate of return based on its systematic risk. In contrast, assets
with estimated rates of return that plot below the SML would be considered overvalued. This position relative
to the SML implies that your estimated rate of return is below what you should require based on the asset’s
systematic risk.
In an efficient market, you would not expect any assets to plot off the SML because, in equilibrium, all stocks
should provide holding period returns that are equal to their required rates of return. Alternatively, a market
that is not completely efficient may misprice certain assets because not everyone will be aware of all the
relevant information.
Identifying Undervalued and Overvalued Assets:
Now that we understand how to compute the rate of return one should expect or require for a specific risky
asset using the SML, we can compare this required rate of return to the asset’s estimated rate of return over a
specific investment horizon to determine whether it would be an appropriate investment.
Assume that analysts at a major brokerage firm have been following the five stocks in the preceding example.
Based on extensive fundamental analysis, they provide you with forecasted price and dividend information for
the next year. Given these projections, you can compute an estimated rate of return for each stock by
summing the expected capital gain ([Pt+1 − Pt]/Pt) and the expected dividend yield (Dt+1/Pt). For example,
the analysts’ estimated future return for Stock A is 8.00 percent (= [26 − 25]/25 + 1/25).
The relationship between the required rate of return for each stock based on its systematic risk as computed
earlier, and its estimated rate of return. This difference between estimated return and expected return is
sometimes referred to as a stock’s expected alpha or its excess return. This alpha can be positive (the stock is
undervalued) or negative (the stock is overvalued). If the alpha is zero (or nearly zero), the stock is on the SML
and is properly valued in line with its systematic risk.
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Plotting these estimated rates of return and stock betas on the SML. Stock A is almost exactly on the line, so it
is considered properly valued because its estimated rate of return is almost equal to its required rate of
return. Stocks B and D are considered overvalued because their estimated rates of return during the coming
period are substantially less than what an investor should expect for the risk involved. As a result, they plot
below the SML. In contrast, Stocks C and E are expected to provide rates of return greater than we would
require based on their systematic risk. Therefore, both stocks plot above the SML, indicating that they are
undervalued.
CAPITAL MARKET LINE:
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Capital market line is the graphical representation of the required return and risk (as measured by standard
deviation) of a portfolio of a risk-free asset and a basket of risky assets that offers the best risk-return trade-
off.
CML is straight line sloping upward indicates that the higher the standard deviation (risk) higher the expected
return.
CML and efficient frontier:
Capital market line represents all possible combinations of portfolios consisting in various proportions
between risk-free asset and market portfolio. On the other hand, an efficient frontier represents all possible
combinations of efficient portfolios, including only risky assets in various proportions.
The intercept point of CML and efficient frontier calls market or tangency portfolio. If investor is rational and
risk-averse it will accept higher risk only when return increase proportionally. From this standpoint tangency
portfolio is most efficient portfolio.
Understanding the CML:
The CML is shown as a straight line. We know that this line has an intercept of RF. If investors are to invest in
risky assets, they must be compensated for this additional risk with a risk premium. The vertical distance
between the risk-free rate and the CML at point M in in diagram is the amount of return expected for bearing
the risk of owning a portfolio of stocks, that is, the excess return above the risk-free rate. At that point, the
amount of risk for the risky portfolio of stocks is given by the horizontal dotted line between RF and σM.
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The slope of the CML is the market price of risk for efficient portfolios. It is also called the equilibrium market
price of risk.4 it indicates the additional return that the market demands for each percentage increase in a
portfolio’s risk, that is, in its standard deviation of return.
The Equation for the CML:
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BETA (β):
Beta is a measure of the volatility–or systematic risk–of a security or portfolio compared to the market as a
whole. Beta is used in the capital asset pricing model (CAPM), which describes the relationship between
systematic risk and expected return, for assets (usually stocks).
CALCULATION OF BETA:
Beta can be computed by any of the following method.
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 If a stock has a beta of 1.0, it indicates that its price activity is strongly correlated with the market.
 A beta value that is less than 1.0 means that the security is theoretically less volatile than the market
 A beta that is greater than 1.0 indicates that the security's price is theoretically more volatile than the
market. For example, if a stock's beta is 1.2, it is assumed to be 20% more volatile than the market.
 Some stocks have negative betas. A beta of -1.0 means that the stock is inversely correlated to the
market benchmark.
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BOOK PROBLEMS:
9-1 The market has an expected return of 12 percent, and the risk-free rate is 5 percent. Pfizer has a beta of
0.73. What is the required rate of return for Pfizer?
SOLUTION: ___________
9-2 The market has an expected return of 14 percent, and the risk-free rate is 4 percent. Activalue Corp. is 80
percent as risky as the market as a whole. What is the required rate of return for this company?
SOLUTION: ___________
9-3 Electron Corporation is 30 percent more volatile than the market as a whole. The market risk premium is 8
percent. The risk-free rate is 5 percent. What is the required rate of return for Electron?
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9-4 The expected return for the market is 12 percent, and the risk-free rate is 4 percent. The following
information is available for each of five stocks.
a. Calculate the required return for each stock.
b. Assume that an investor, using fundamental analysis, develops the estimates of expected return labeled E
(Ri) for these stocks. Determine which stocks are undervalued and which are overvalued.
c. What is the market’s risk premium?
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9-5 Assume that the risk-free rate is 7 percent and the expected market return is 13 percent. Show that the
security market line is
E (Ri)=7.0 þ 6.0β
Assume that an investor has estimated the following values for six different corporations:
Calculate the ERi for each corporation using the SML, and evaluate which securities are overvalued and which
are undervalued.
SOLUTION_________
COMPUTATIONAL PROBLEMS:
9-2 Assume that Exxon is priced in equilibrium. Its expected return next year is 14 percent, and its beta is 0.41.
The risk-free rate is 6 percent.
a. Calculate the slope of the SML.
b. Calculate the expected return on the market.
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9-3 Given the following information:
Expected return for the market, 12 percent; Standard deviation of market return, 21 percent; Risk-free rate, 4
percent; Correlation coefficient between Stock A and the market, 0.8; Stock B and the market, 0.6; Standard
deviation for stock A, 25 percent; Standard deviation for stock B, 30 percent.
a. Calculate the beta for stock A and stock B.
b. Calculate the required return for each stock.
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9-4 The expected return for the market is 12 percent, with a standard deviation of 21 percent. The expected
risk-free rate is 4 percent. Information is available for five mutual funds, all assumed to be efficient:
a. Calculate the slope of the CML.
b. Calculate the expected return for each portfolio.
c. Rank the portfolios in increasing order of expected risk.
d. Do any of the portfolios have the same expected return as the market? Why?
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Capital Market Theory

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Capital Market Theory

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Investment Analysis & Portfolio Management Asset Pricing Principles

CAPITAL MARKET THEORY

CAPITAL ASSET PRICING MODEL (CAPM):

ASSUMPTIONS OF CAPITAL ASSET PRICING MODEL/CAPITAL MARKET THEORY:

Following are the assumptions of capital asset pricing model.

ERi = Rf+ (ERm−Rf) βi

Assume the following for Asset XYZ:

SECURITY MARKET LINE (SML):

Determining the Expected Rate of Return for a Risky Asset:

Identifying Undervalued and Overvalued Assets:

CAPITAL MARKET LINE:

CML and efficient frontier:

Understanding the CML:

portfolio’s risk, that is, in its standard deviation of return.

The Equation for the CML:

Beta can be computed by any of the following method.

a. Calculate the required return for each stock.

c. What is the market’s risk premium?

a. Calculate the slope of the SML.

b. Calculate the expected return on the market.

9-3 Given the following information:

a. Calculate the slope of the CML.

b. Calculate the expected return for each portfolio.

c. Rank the portfolios in increasing order of expected risk.

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