Chapter 13

Capital Asset Pricing

Theory
Theory
 CHAPTER 13 OVERVIEW

13.1 Portfolio Theory

13.2 Capital Asset Pricing Model
13.3 Expected Return and Risk
13.4 Empirical Criticisms of Beta
13.5 Arbitrage Pricing Theory
Portfolio Theory

 Investment Portfolio:
collection of securities that
together provide an investor
with an attractive trade-off
between risk and return
 Portfolio Theory: concept of
making security choices based
on portfolio expected returns
and risks
 PORTFOLIO THEORY
Basic Assumptions
 Expected Return: anticipated profit over some relevant
holding period
 Risk: return dispersion, usually measured by standard
deviation of returns
 Probability Distribution: apportionment of likely
occurrences
 Utility: positive benefit
 Disutility: psychic loss
 Risk Averse: desire to avoid risk
 PORTFOLIO THEORY
Three Fundamental Assertions

 Investors seek to maximize utility.

 Investors are risk averse: Utility rises with

expected return and falls with an increase in
volatility.
 The optimal portfolio has the highest expected
return for a given level of risk, or the lowest
level of risk for a given expected return.
 Portfolio Expected Rate
of Return and Risk
Expected rate of return:

E  Rp    Wi E  Ri 
N

i 1

Standard deviation (risk):

SD  R p    VAR  Ri    Wi  W j  COV  Ri R j 
N N N

W
2
1
i 1 i 1 j 1
Figure 13.2 (c)
INVESTMENT
INVESTMENT OPPORTUNITY
OPPORTUNITY FUNDAMENTALS
FUNDAMENTALS
Expected Rate of Return & Risk
Portfolio risk increases with the
volatility of individual holdings
and the extent to which holding
have high covariance.
 Optimal Portfolio Choice

 Zero-Risk Portfolio: constant return portfolio

 Efficient Portfolio: portfolio with maximum expected
return for a given level of risk, or minimum risk for a
given expected return
 Efficient Frontier: collection of all efficient portfolios
 Optimal Portfolio: collection of securities that provides
an investor with the highest level of expected utility
 Market Portfolio: all tradable assets
Capital Asset Pricing Model
(CAPM)

Method for predicting

how investment returns
are determined in an
efficient capital market
 KEY TERMS
Capital Asset Pricing Model
 capital market line (CML)
 security market line (SML)
 systematic risk
 unsystematic risk
 diversifiable risk
 nondiversifiable risk
 security characteristic line
(SCL)
 positive abnormal returns
 negative abnormal return
 market index bias
 model specification bias
 time interval bias
 nonstationary beta problem
 arbitrage pricing theory (APT)
 arbitrage
 CAPITAL ASSET PRICING MODEL
Basic Assumptions
 Investors hold efficient portfolios; higher expected returns
involve higher risk.
 Unlimited borrowing and lending are available at the risk-
free rate.
 Investors have homogeneous expectations.
 There is a one-period time horizon.
 Investments are infinitely divisible.
 No taxes or transaction costs exist.
 Inflation is fully anticipated.
 Capital markets are in equilibrium.
 CAPM & Market
Efficiency

 CAPM can test Efficient Market Hypothesis.

 Market is efficient if only risk-free assets give risk-

free rates of return (e.g., Treasury bills).
 Deviations may indicate opportunities.

 Modeling predictions can suggest improvements to

market functioning.
 Lending & Borrowing Under
the CPM
 Assumption of unlimited lending and borrowing at
risk-free rate.
 Lending if portion of portfolio held in risk-free
assets.
 Borrowing (leverage) if more than 100% of
portfolio is invested in risky assets.
 Superior returns made possible with lending and
borrowing; creates spectrum of risk preference for
different investors.
 CAPITAL ASSET PRICING MODEL
Three Linear Relationships

 Capital Market Line: linear risk-return trade-off for

all investment portfolios
 Security Market Line: linear risk-return trade-off
for individual stocks
 Security Characteristic Line: linear relation
between the return on individual securities and the
overall market at every point in time
 CAPITAL ASSET PRICING MODEL
Three Linear Relationships

 Capital Market Line: linear risk-return trade-off for

all investment portfolios
E(R)
M
Rf
 = market 

Standard Deviation (total portfolio risk)

 EXPECTED RETURN & RISK
The Capital Market Line (CML)

Linear risk-return trade-off for all investment portfolios given by

E  RM   RF
E  RP   RF  SD RP 
SD RM 
SD RP 
 RF 
SD RM 
 E  RM   RF 
Figure 13.4
EXPECTED RETURN & RISK
The Capital Market Line (CML)
 Security Market Line (SML)

 Security Market Line: linear risk-return trade-off for

individual stocks
 Systematic Risk: return volatility tied to overall
market; also called nondiversifiable risk
 Unsystematic Risk: return volatility tied specifically to
an individual company; also called diversifiable risk
 Beta: sensitivity of a security’s returns to the
systematic market risk factor
 CAPITAL ASSET PRICING MODEL
Three Linear Relationships

 Security Market Line: linear risk-return trade-off

for all individual stocks
E(R)
M
Rf
=1

Systematic Risk
Figure 13.5

The BETA Factor

 The Security
Characteristic Line
 Linear relation between the return on individual securities and
the overall market at every point in time, given by:

Rit   i  i RMt  i
 Positive Abnormal Returns: above-average returns that can’t
be explained as compensation for added risk
 Negative Abnormal Returns: below-average returns that
cannot be explained by below-market risk
 Empirical Implications of
CAPM

 Optimal portfolio choice depends on market risk-return trade-offs

and individual investors’ differences in risk preferences.
 Relation between expected return and risk is linear for all
portfolios and individual assets.
 Expected rate of return is risk-free rate plus relative risk (ßp)
times market risk premium.
 High beta portfolios earn high risk premiums.
 Low beta portfolios earn low risk premiums.
 Stock price  measures relevant risk for all securities.
 EMPIRICAL CRITICISMS OF BETA
MODEL
MODEL SPECIFICATION
SPECIFICATION PROBLEMS
PROBLEMS

 CAPM provides only incomplete description of return volatility

—volatility in individual issues can only be described as a
function of overall market volatility.
 Overall market volatility very difficult to measure
 Market Index Bias: distortion to beta estimates due to fact that
indexes are imperfect proxies for overall market
 No single index includes all capital assets, including stocks,
bonds, real estate, collectibles, etc.
 Model Specification Bias: distortion to beta estimates because
SCL fails to include other important systematic influences on
stock market volatility
 EMPIRICAL CRITICISMS OF BETA
Data
Data Interval
Interval && Nonstationary
Nonstationary Beta
Beta Problems
Problems

 Data Interval Problem: beta

estimation problem derived
from the fact that beta
estimates depend on data
interval studied
 Nonstationary Beta Problem:
difficulty tied to the fact that
betas are inherently unstable
 Testable Limitations Of
CAPM

 ß, the slope of the regression of a security’s return on

the market return, is the only risk factor needed to
explain expected return.
 ß captures a positive expected return premium for risk.

 Other risk factors emerge:

 firm size
 low P/E, price/cash flow, P/B, and sales growth
 Arbitrage Pricing Theory
(APT)

 Multifactor asset-pricing model that allows

market ßs to represent only one of the firm’s
many risk factors.
 Arbitrage: simultaneous buying and selling of
the same asset at different maturities
 APT suggests that asset returns might be
affected by N risk factors.
 APT vs. CPM

 Volatile returns attributable to six-factor APT

models are very unstable—explain very little of
variation in average returns.
 Though both CAPM and APT theory and
evidence confirm relationship between risk and
return, neither approach gives precise estimates.
 Neither provides foolproof test of EMF.
 KEY TERMS
Capital Asset Pricing

 investment portfolio  risk averse

 portfolio theory  zero-risk portfolio

 expected return  efficient portfolio

 efficient frontier
 risk
 optimal portfolio
 probability distribution
 market portfolio
 utility
 capital asset pricing
 disutility model