CHAPTER 9 The Capital Asset

Pricing Model

Investments, 8th edition

Bodie, Kane and Marcus

Slides by Susan Hine

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Capital Asset Pricing Model (CAPM)
• It gives a precise prediction of the relationship
that should be observed between the risk of an
asset and its expected return.
• Beneftis:
– Provides benchmark rate of return for evaluating possible
investments
– Helps to make an educated guess as to the expected return
on assets that have not yet been traded in the marketplace
• It is the equilibrium model
• Derived using principles of diversification with
simplified assumptions
• Markowitz, Sharpe, Lintner and Mossin 9-2
 Assumptions
• Individual investors are price takers: they act
as though security prices are unaffected by
their own trades (their wealth is small
compared to the total wealth of all investors)
• Single-period investment horizon: myopic-
short-sighted behavior (ignores everything
that might happen after the end of the single
period horizon)
• Investments are limited to traded financial
assets: (traded financial assets –bonds and
stocks) and risk-free borrowing or lending)
9-3
 Assumptions Continued
• No taxes and transaction costs
• Information is costless and available to all
investors
• Investors are rational mean-variance
optimizers: all investors use Markowitz
Portfolio Selection Model (minimum-variance
frontier, efficient frontier, CAL, optimal risky
portfolio and optimal complete portfolio)
• There are homogeneous expectations: all
investors analyze securities in the same way
and share the same economic view
9-4
 Resulting Equilibrium Conditions

• All investors will hold the same portfolio for

risky assets – market portfolio
• Market portfolio contains all securities (all
traded assets) and the proportion of each
security is its market value as a percentage
of total market value
• Market portfolio:
– on the efficient frontier
– The tangency portfolio to the optimal CAL

9-5
Figure 9.1 The Efficient Frontier and the
Capital Market Line

9-6
 Resulting Equilibrium Conditions
Continued
• Risk premium on the market depends on the
average risk aversion of all market
participants
• Risk premium on an individual security is a
function of its covariance with the market

9-7
 Market Risk Premium

•The risk premium on the market portfolio will

be proportional to its risk and the degree of risk
aversion of the investor:
E (rM )  rf  A M2 X 0.01

where  2
M is the variance of the market portolio and
A is the average degree of risk aversion across investors

9-8
Return and Risk For Individual Securities

• The risk premium on individual securities is a

function of the individual security’s
contribution to the risk of the market portfolio
• An individual security’s risk premium is a
function of the covariance of returns with the
assets that make up the market portfolio

9-9
 Using GE Text Example

• Covariance of GE return with the market

portfolio:
 n
 n
Cov(rGE , rM )  Cov  rGE ,  wk rk    wk Cov(rk , rGE )
 k 1  k 1

• Therefore, the reward-to-risk ratio for

investments in GE would be:
GE's contribution to risk premium wGE  E (rGE )  rf  E (rGE )  rf
 
GE's contribution to variance wGE Cov(rGE , rM ) Cov(rGE , rM )

9-10
Using GE Text Example Continued
• Reward-to-risk ratio for investment in
market portfolio:
Market risk premium E (rM )  rf

Market variance  M2

• Reward-to-risk ratios of GE and the market

Basic
portfolio: E (rGE )  rf E (rM (rf ) Principle: all
 investments
Cov(rGE , rM )  2
M should offer
the same
• And the risk premium for GE: reward-to-risk
raito.
Cov(rGE , rM )
 E (rM )  rf 
Otherwise
E (rGE )  rf 
 2 investors will
M rearrange
their
portfolios.
9-11
 Expected Return-Beta Relationship

• CAPM holds for the overall portfolio because:

E (rP )   wk E (rk ) and
k

 P   wk  k
k
• This also holds for the market portfolio:

E (rM )  rf   M  E (rM )  rf 

9-12
Figure 9.2 The Security Market Line

9-13
Figure 9.3 The SML and a Positive-
Alpha Stock
Alpha: the
difference
between the
fair and the
actual
expected rates
of return

9-14
 The CAPM and Reality

• Is the condition of zero alphas for all stocks

as implied by the CAPM met
– Not perfect but one of the best available
• Is the CAPM testable
– Proxies must be used for the market
portfolio
• CAPM is still considered the best available
description of security pricing and is widely
accepted

9-15
 Extensions of the CAPM
• Zero-Beta Model
– Helps to explain positive alphas on low
beta stocks and negative alphas on high
beta stocks
• Consideration of labor income and non-
traded assets
• Merton’s Multiperiod Model and hedge
portfolios
– Incorporation of the effects of changes in
the real rate of interest and inflation
9-16
 Extensions of the CAPM Continued

• A consumption-based CAPM
– Models by Rubinstein, Lucas, and Breeden
• Investor must allocate current wealth between
today’s consumption and investment for the future

9-17
 Liquidity and the CAPM

• Liquidity
• Illiquidity Premium
• Research supports a premium for illiquidity.
– Amihud and Mendelson
– Acharya and Pedersen

9-18
Figure 9.5 The Relationship Between
Illiquidity and Average Returns

9-19
 Three Elements of Liquidity

• Sensitivity of security’s illiquidity to market

illiquidity:  L1  Cov(Ci , CM )
Var ( RM  CM )

• Sensitivity of stock’s return to market

illiquidity:   Cov( R , C )
i M
Var ( RM  CM )
L2

• Sensitivity of the security illiquidity to the

market rate of return:
Cov(Ci , RM )
 L3 
Var ( RM  CM )

9-20