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The Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM)
CAPM links the expected (excess) returns on a risky asset to its risk in an efficient portfolio The expected excess return on a risky asset or a portfolio of assets is its expected return over and above the riskfree return A portfolio is said to be efficient if among all possible portfolios with the same excess return it has the lowest variance
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The CAPM
Consider a portfolio consisting of assets i = 1, 2....N A necessary condition for a portfolio to be efficient is
E( r* - r) i = for all i = 1,2... N *) cov(r*, rp i
where ri* and rp* denote, respectively return on asset i and the portfolio
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The CAPM
The numerator is the contribution of asset i to the portfolio's excess return while the denominator is the contribution of asset i to the portfolio's variance or risk The parameter is known as the investor's relative risk aversion and is a measure of his or her attitude towards risk
The CAPM
Two fund theorem" says that in equilibrium all
investors will hold some combination of the riskfree asset and the so-called "tangency portfolio" One of the crucial ingredients in the CAPM is the notion of Market Portfolio Now let rp be the market portfolio. Denote the return on market portfolio by rm For the market portfolio to be efficient we must have
The CAPM
This can be written as follows
*) E(r* - r) = cov(r*, rm i i
* 2 E(ri - r) = m im 2 m
(1)
(2)
E(rm* - r) = 2m
(3)
The CAPM
Rewriting = [E(rm* - r)/m2] Replace [ m2] by E(rm* - r) and recall the definition of the beta of asset i to get E(ri* - r) = i E(rm* - r) This is the one country CAPM The only source of systematic risk is the market risk.
The CAPM
im denotes the covariance between the returns on asset i and the market portfolio and m2 denotes the variance of the return on the market portfolio The expression [im/m2] is the familiar "Beta" of the asset i, denoted i which measures the covariance of asset i with the market portfolio
The CAPM
The parameter i is estimated by means of a regression of realized historical returns on asset i on the realized historical returns on the market portfolio ri* = i + i rm* + ui OLS estimator of i = Cov (ri*, rm*)/Var (rm*)
Lintner
First regression Rit = i + biRmt + eit yearly returns, 301 common stocks, 19541963 Second regression Ri = a1 + a2bi + a3S 2ei + i S 2ei is the variance of the fitted residual from the first regression. If the standard CAPM is true then a1 should equal Rf, a2 should equal Rm-Rf, and a3 should equal zero. If the Zero-Beta CAPM is true then a1 should equal Rz, a2 should equal (Rm-Rz ) and a3 should equal zero. The result was a1 = 0.108 a2 = 0.063 a3 = 0.237 (both a2 and a3 are significantly different from zero at the 0.01 level) Seems to violate the CAPM!
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International CAPM
A Two Country CAPM: Ignore inflation Consider a German investor computing returns on various assets in terms of his home currency EUR. Denote by S the USD/EUR exchange rate.: (1) A US T-bill : rGE = rUS + where rUS is the return in USD terms. Thus correlation between rGE and is +1. (2) What about a US stock? (3) What about a German stock?
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An appreciation of the dollar against the Euro will increase euro return for a given dollar return.
However, will it help or hurt the valuation of the US firm? A US exporter firm export sales might decline due to appreciation. But interest and labour costs might also decline. Net impact? On balance correlation between S and return on US stocks measured in EUR positive or negative?
What about a German firm? EUR depreciation might help if strong US market presence. Costs might increase. Net impact again ambiguous.
Many empirical studies using firm-level data from do not show up an exchange rate factor in stock returns after the market factor is included.
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var (rW)
cov (, rW) =
cov (rW, )
var()
E(rW r) E(r* + r)
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var(rW)
cov (, rW) =
cov (rW, ) -1
var()
E(rW r)
E(r* + r)
The asset now has two betas correlation with world market and with the exchange rate.
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cov(rw, )
var()
cov(ri, )
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Substitute for [ ]
var(rW) cov (rW, ) -1 E(rW r)
cov (, rW)
=
var()
E(r* + r)
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E(ri r) = cov (ri, rw) var(rW) cov (rW, ) -1 cov (ri, ) cov (, rW) Which leads to E(ri r) = [ i i ] E(rW r) E(r* + r) var()
E(rW r) E(r* + r)
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