CAPM

Capital Asset Pricing Model

By Martin Swoboda and Sharon Lu

Introduction
 Modern Portfolio Theory and
diversification
 Beta vs. standard deviation
 Unsystematic vs. systematic risk
 Security Market Line (SML)
 The CAPM equation
 Asset pricing
 Assumptions behind using CAPM
Modern Portfolio Theory and
diversification
 Rational investors use diversification to
optimize their portfolios
 Diversification reduces portfolio risk
(assets that are not perfectly correlated)
 Efficient Portfolio
Beta vs. standard deviation
 Standard deviation includes systematic
and unsystematic risk; not used because
unsystematic risk diversified away

 Beta: A standardized measure of the risk

of an individual asset, one that captures
only the systematic component of its
volatility; measures how sensitive an
individual security is to market movements;
measure of market risk
Unsystematic vs. systematic risk

 Unsystematic risk: risk that can be eliminated

through diversification
 a.k.a. Unique risk, residual risk, specific risk, or diversifiable risk

 Systematic risk: risk that cannot be

eliminated through diversification
 a.k.a, market risk or undiversifiable risk
Security Market Line
 Line representing the relationship between
expected return and market risk; shows
expected return of an overall market as a
function of systematic risk
 Graphical representation of CAPM
 Compare a single asset to the SML (and
see if it falls below, above, or on the line)
Security Market Line
Capital Asset Pricing Model
(CAPM)

The expected return on a specific asset equals

the risk-free rate plus a premium that depends
on the asset’s beta and the expected risk
premium on the market portfolio.

Expected return of specific asset: E(Ri)

Risk-free rate: Rf
Expected risk premium: E(Rm) - Rf
Practice Problem #1
 If the risk-free rate equals 4% and a stock
with a beta of 0.8 has an expected return
of 10%, what is the expected return on the
market portfolio?
Practice Problem #1: answer
 If the risk-free rate equals 4% and a stock
with a beta of 0.75 has an expected return
of 10%, what is the expected return on the
market portfolio?
 10% = 4% + 0.75(market portfolio – 4%)
 8% = market portfolio – 4%
 12% = market portfolio
Practice Problem #2
 A particular asset has a beta of 1.2 and an
expected return of 10%. Given that the
expected return on the market portfolio is
13% and the risk-free rate is 5%, the stock
is:
A. appropriately priced
B. underpriced
C. overpriced
Practice Problem #2: answer
 A particular asset has a beta of 1.2 and an
expected return of 10%. Given that the
expected return on the market portfolio is
13% and the risk-free rate is 5%, the stock
is:
A. appropriately priced
B. underpriced
C. overpriced; expected return should
be 14.6% (5+1.2(13-5))
Asset pricing
 Future cash flows of the asset can be
discounted using the expected return
calculated from CAPM to establish the
price of the asset
 If observed price > CAPM valuation 
overvalued (paying too much for that
amount of risk)
 If observed price < CAPM valuation 
undervalued
Assumptions behind the CAPM
 U.S. treasuries are risk-free
 Uncertainty about inflation
 Assumed that investors can borrow money
at same interest rate at which they lend,
but generally borrowing rates are higher
than lending rates
 WHY we still use CAPM: benchmark
portfolios used  Treausry bills and
market portfolio
Practice Problem #3
Last year…
 Firm A: return: 10%, beta: 0.8
 Firm B: return: 11%, beta: 1.0
 Firm C: return: 12%, beta: 1.2
 Given that the risk-free rate was 3% and
market return was 11%, which firm had the
best performance?
Practice Problem #3: answer

 Firm A: 3% + 0.8(11%-3%) = 9.4% (over)

 Firm B: 3% + 1.0(8%) = 11% (same)
 Firm C: 3% + 1.2(8%) = 12.6% (under)

Firm A performed the best because it

exceeded the expected return