1

The Capital Asset Pricing

Corporate Finance
Ross Westerfield Jaffe
 
Model (CAPM) Sixth Edition
2

Outline
1 Individual Securities
2 Expected Return, Variance, and Covariance
3 The Return and Risk for Portfolios
4 The Efficient Set for Two Assets
5 The Efficient Set for Many Securities
6 Diversification: An Example
7 Riskless Borrowing and Lending
8 Market Equilibrium
9 Relationship between Risk and Expected Return (CAPM)
10 Summary and Conclusions
3

1 Individual Securities
• The characteristics of individual securities that are of interest
are the:
– Expected Return
– Variance and Standard Deviation
– Covariance and Correlation
4

2 Expected Return, Variance, and Covariance

Rate of Return
Scenario Probability Stock fund Bond fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%

Consider the following two risky asset world. There is a 1/3

chance of each state of the economy and the only assets are a
stock fund and a bond fund.
5

2 Expected Return, Variance, and Covariance

Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
6

2 Expected Return, Variance, and Covariance

Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

E (rS )  1  (7%)  1  (12%)  1  (28%)

3 3 3
E (rS )  11 %
7

2 Expected Return, Variance, and Covariance

Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

E (rB )  1  (17%)  1  (7%)  1  (3%)

3 3 3
E (rB )  7%
8

2 Expected Return, Variance, and Covariance

Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

(11 %  7%)  3.24%

2
9

2 Expected Return, Variance, and Covariance

Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

(11 %  12%)  .01%

2
10

2 Expected Return, Variance, and Covariance

Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

(11 %  28%)  2.89%

2
11

2 Expected Return, Variance, and Covariance

Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

1
2.05%  (3.24%  0.01%  2.89%)
3
12

2 Expected Return, Variance, and Covariance

Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

14.3%  0.0205
13

3 The Return and Risk for Portfolios

Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

Note that stocks have a higher expected return than bonds

and higher risk. Let us turn now to the risk-return tradeoff
of a portfolio that is 50% invested in bonds and 50%
invested in stocks.
14

• For calculating the Return of a portfolio of two assets we

will use the same formula but with but conceptual
interpretation is different
• The expected return of a portfolio is wieghted average of the
individual retrun of each investment in the portfolio

rP  w1r1  w2 r2  w3 r3  ......  wn rn
• Consider a portfolio consists of 50% of Stock and 50% of
Bond
15

3 The Return and Risk for Portfolios

Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

The rate of return on the portfolio is a weighted average of

the returns on the stocks and bonds in the portfolio:
rP  wB rB  wS rS
5%  50%  (7%)  50%  (17%)
16

3 The Return and Risk for Portfolios

Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

The rate of return on the portfolio is a weighted average of

the returns on the stocks and bonds in the portfolio:
rP  wB rB  wS rS

9.5%  50%  (12%)  50%  (7%)

17

3 The Return and Risk for Portfolios

Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

The rate of return on the portfolio is a weighted average of

the returns on the stocks and bonds in the portfolio:
rP  wB rB  wS rS

12.5%  50%  (28%)  50%  (3%)

18

3 The Return and Risk for Portfolios

Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

The expected rate of return on the portfolio is a weighted

average of the expected returns on the securities in the
portfolio.
E (rP )  wB E (rB )  wS E (rS )

9%  50%  (11%)  50%  (7%)

19

Risk
• Here you can not calculate the simple weighted average
• An effect that an investment has on the risk of another
investment.
• When we talk about the collection of many assets, level of
risk decreases as the number of invements increase, reason is
that the random risk or co. specific risk is cancelled out
across the different investments
20

• In other words positive random risk for a particular share

might be cancelled or offset by the negative random risk of
some other investment the net effect of co specific risk
cancells out
• Risk or SD of portfolio of two stocks is
21

• In other words positive random risk for a particular share

might be cancelled or offset by the negative random risk of
some other investment the net effect of co specific risk
cancells out
• Risk or SD of portfolio of two stocks is

σ P2  (wB σ B ) 2  (wS σ S ) 2  2(wB σ B )(wS σ S )ρ BS

22

3 The Return and Risk for Portfolios

Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

The variance of the rate of return on the two risky assets

portfolio is , if the BS = -.8
σ P2  (wB σ B ) 2  (wS σ S ) 2  2(wB σ B )(wS σ S )ρ BS
where BS is the correlation coefficient between the returns
on the stock and bond funds.
23

3 The Return and Risk for Portfolios

Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

Observe the decrease in risk that diversification offers.

An equally weighted portfolio (50% in stocks and 50%
in bonds) has less risk than stocks or bonds held in
isolation.
24

4 The Efficient Set for Two Assets

% in stocks Risk Return Portfolo Risk and Return Combinations
0% 8.2% 7.0%
5% 7.0% 7.2% 12.0%

Portfolio Return
10% 5.9% 7.4% 11.0%
15% 4.8% 7.6% 10.0% 100%
20% 3.7% 7.8% 9.0% stocks
25% 2.6% 8.0% 8.0%
30% 1.4% 8.2% 7.0%
35% 0.4% 8.4% 100%
6.0%
40% 0.9% 8.6% bonds
5.0%
45% 2.0% 8.8%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
50.00% 3.08% 9.00%
55% 4.2% 9.2% Portfolio Risk (standard deviation)
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0% We can consider other
80% 9.8% 10.2% portfolio weights besides
85% 10.9% 10.4%
90% 12.1% 10.6% 50% in stocks and 50% in
95%
100%
13.2%
14.3%
10.8%
11.0%
bonds …
25

Portfolo Risk and Return Combinations

12.0%
Portfolio Return

11.0%
10.0%
9.0%
8.0%
7.0%
6.0%
5.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%

Portfolio Risk (standard deviation)

26

4 The Efficient Set for Two Assets

% in stocks Risk Return Portfolo Risk and Return Combinations
0%
0% 8.2%
8.2% 7.0%
7.0%
5%
5% 7.0%
7.0% 7.2%
7.2% 12.0%

Portfolio Return
10%
10% 5.9%
5.9% 7.4%
7.4% 11.0%
15%
15% 4.8%
4.8% 7.6%
7.6% 10.0% 100%
20%
20% 3.7%
3.7% 7.8%
7.8% 9.0% stocks
25%
25% 2.6%
2.6% 8.0%
8.0% 8.0%
30%
30% 1.4%
1.4% 8.2%
8.2% 7.0%
100%
35%
35% 0.4%
0.4% 8.4%
8.4% 6.0%
bonds
40%
40% 0.9%
0.9% 8.6%
8.6% 5.0%
45%
45% 2.0%
2.0% 8.8%
8.8% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
50%
50% 3.1%
3.1% 9.0%
9.0%
55%
55% 4.2%
4.2% 9.2%
9.2% Portfolio Risk (standard deviation)
60%
60% 5.3%
5.3% 9.4%
9.4%
65%
65% 6.4%
6.4% 9.6%
9.6%
70%
70%
75%
7.6%
7.6%
8.7%
9.8%
9.8%
10.0%
We can consider other
75% 8.7% 10.0%
80%
80% 9.8%
9.8% 10.2%
10.2% portfolio weights besides
85%
85% 10.9%
10.9% 10.4%
10.4%
90%
90% 12.1%
12.1% 10.6%
10.6%
50% in stocks and 50% in
95%
95% 13.2%
13.2% 10.8%
10.8% bonds …
100%
100% 14.3%
14.3% 11.0%
11.0%
27

4 The Efficient Set for Two Assets

% in stocks Risk Return Portfolo Risk and Return Combinations
0% 8.2% 7.0%
5% 7.0% 7.2% 12.0%

Portfolio Return
10% 5.9% 7.4% 11.0%
15% 4.8% 7.6% 10.0% 100%
20% 3.7% 7.8% 9.0% stocks
25% 2.6% 8.0% 8.0%
30% 1.4% 8.2% 7.0% 100%
35% 0.4% 8.4% 6.0% bonds
40% 0.9% 8.6% 5.0%
45% 2.0% 8.8% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
50% 3.1% 9.0%
55% 4.2% 9.2% Portfolio Risk (standard deviation)
60% 5.3% 9.4%
65% 6.4% 9.6% Note that some portfolios are
70% 7.6% 9.8%
75% 8.7% 10.0% “better” than others. They have
80% 9.8% 10.2% higher returns for the same level of
85% 10.9% 10.4%
90% 12.1% 10.6% risk or less.These compromise the
95%
100%
13.2%
14.3%
10.8%
11.0%
efficient frontier.
28
Two-Security Portfolios with Various
Correlations

return
100%
 = -1.0 stocks

 = 1.0
100%
 = 0.2
bonds


29 Portfolio Risk/Return Two Securities:
Correlation Effects
• Relationship depends on correlation coefficient
• -1.0 <  < +1.0
• The smaller the correlation, the greater the risk reduction
potential
• If= +1.0, no risk reduction is possible
30

5 The Efficient Set for Many Securities

return

Individual Assets

P
Consider a world with many risky assets; we can still identify
the opportunity set of risk-return combinations of various
portfolios.
31

5 The Efficient Set for Many Securities

return minimum
variance
portfolio

Individual Assets

P

Given the opportunity set we can identify the minimum

variance portfolio.
32

5 The Efficient Set for Many Securities

return
o nt i er
r
ie nt f
c
effi
minimum
variance
portfolio

Individual Assets

P

The section of the opportunity set above the minimum variance

portfolio is the efficient frontier.
33
Optimal Risky Portfolio with a Risk-Free Asset

return
100%
stocks

rf
100%
bonds

In addition to stocks and bonds, consider a world that also has

risk-free securities like T-bills
34
7 Riskless Borrowing and Lending

return
CM 100%
stocks
Balanced
fund

rf
100%
bonds

Now investors can allocate their money across the T-bills and a
balanced mutual fund
35

7 Riskless Borrowing and Lending

return
L
CM efficient frontier

rf

P
With a risk-free asset available and the efficient
frontier identified, we choose the capital allocation line
with the steepest slope
36

8 Market Equilibrium

return
L
CM efficient frontier

rf

P
With the capital allocation line identified, all investors
choose a point along the line—some combination of the
risk-free asset and the market portfolio M. In a world with
homogeneous expectations, M is the same for all investors.
37

The Separation Property

return
L
CM efficient frontier

rf

P
The Separation Property states that the market portfolio, M, is the same
for all investors—they can separate their risk aversion from their
choice of the market portfolio.
38

The Separation Property

return
L
CM efficient frontier

rf

P
Investor risk aversion is revealed in their choice of where to
stay along the capital allocation line—not in their choice of
the line.
39

Market Equilibrium

return
CM 100%
stocks
Balanced
fund

rf
100%
bonds


Just where the investor chooses along the Capital Asset
Line depends on his risk tolerance. The big point though
is that all investors have the same CML.
40

Market Equilibrium

return
CM 100%
stocks
Optimal
Risky
Porfolio

rf
100%
bonds


All investors have the same CML because they all have the
same optimal risky portfolio given the risk-free rate.
41

The Separation Property

return
CM 100%
stocks
Optimal
Risky
Porfolio

rf
100%
bonds


The separation property implies that portfolio choice can be
separated into two tasks: (1) determine the optimal risky
portfolio, and (2) selecting a point on the CML.
42
Optimal Risky Portfolio with a Risk-Free Asset

L 0 CML 1

return
CM 100%
stocks

1 First Second Optimal

r f Optimal Risky Portfolio
0 Risky
r f Portfolio
100%
bonds

By the way, the optimal risky portfolio depends on the risk-

free rate as well as the risky assets.
43
Definition of Risk When Investors Hold the
Market Portfolio
• Researchers have shown that the best measure of the risk of
a security in a large portfolio is the beta ()of the security.
• Beta measures the responsiveness of a security to
movements in the market portfolio.

Cov( Ri , RM )
i 
 ( RM )
2
44
Estimating with regression

Security Returns
i ne
c L
s t i
r i
c t e
a
har
C Slope = i
Return on
market %

R i =  i +  i Rm + e i
45

Estimates of  for Selected Stocks

Stock Beta
Bank of America 1.55
Borland International 2.35
Travelers, Inc. 1.65
Du Pont 1.00
Kimberly-Clark Corp. 0.90
Microsoft 1.05
Green Mountain Power 0.55
Homestake Mining 0.20
Oracle, Inc. 0.49
46

The Formula for Beta

Cov( Ri , RM )
i 
 ( RM )
2

Clearly, your estimate of beta will depend upon

your choice of a proxy for the market portfolio.
47
9 Relationship between Risk and Expected
Return (CAPM)
• Expected Return on the Market:

R M  RF  Market Risk Premium

• Expected return on an individual security:

R i  RF  β i  ( R M  RF )

Market Risk Premium

This applies to individual securities held within well-
diversified portfolios.
48

Expected Return on an Individual Security

• This formula is called the Capital Asset Pricing

Model (CAPM)
R i  RF  β i  ( R M  RF )
Expected
Risk- Beta of the Market risk
return on = + ×
free rate security premium
a security

• Assume i = 0, then the expected return is RF.

• Assume i = 1, then R i  R M
49
Relationship Between Risk & Expected Return

Expected return R i  RF  β i  ( R M  RF )

RM

RF

1.0 

R i  RF  β i  ( R M  RF )
50
Relationship Between Risk & Expected Return

Expected
return
13.5%

3%

1.5 
β i  1.5 RF  3% R M  10%
R i  3%  1.5  (10%  3%)  13.5%
51

10 Summary and Conclusions

• This presentation sets forth the principles of modern
portfolio theory.
• The expected return and variance on a portfolio of two
securities A and B are given by
E (rP )  wA E (rA )  wB E ( rB )

σ P2  (wAσ A )2  (wB σ B )2  2(wB σ B )(wAσ A )ρ AB

• By varying wA, one can trace out the efficient set of
portfolios. We graphed the efficient set for the two-asset
case as a curve, pointing out that the degree of curvature
reflects the diversification effect: the lower the correlation
between the two securities, the greater the diversification.
• The same general shape holds in a world of many assets.
52

10 Summary and Conclusions

• The efficient set of risky assets can be combined with
riskless borrowing and lending. In this case, a rational
investor will always choose to hold the portfolio of risky
securities represented by the market portfolio.
• Then with

return
borrowing or L
lending, the CM efficient frontier
investor selects a
point along the M
CML.
rf

P
53

10 Summary and Conclusions

• The contribution of a security to the risk of a well-
diversified portfolio is proportional to the covariance of the
security's return with the market’s return. This contribution
is called the beta. Cov( R R )
i  i, M

 2 ( RM )
• The CAPM states that the expected return on a security is
positively related to the security’s beta:

R i  RF  β i  ( R M  RF )