Portfolio

Management and
Wealth Planning
CAPM
Capital Asset Pricing Model
(CAPM)
 Harry Markovitz laid down the foundation of modern
portfolio management in 1952. Nearly 12 years later,
 The CAPM was introduced by Treynor (1961, 1962),
 Sharpe (1964),  Lintner (1965a,b) and Mossin (1966)
independently, building on the earlier work of
Markowitz on diversification and modern portfolio
theory.
 Sharpe, Markowitz and Miller jointly received the 1990
Nobel Memorial Prize in Economics for this contribution.
ASSUMPTIONS

 CAPM assumes that investors are single-period planners.

 CAPM assumes that SECURITY MARKETS ARE IDEAL:
a) they are large, investors are price takers
b) there are no taxes and transaction costs
c) All risky assets are publicly traded
d) Investors can borrow and lend any amount at a fixed
risk-free rate
 According to CAPM; all investors will choose to hold a portfolio of risky
assets in proportions that dublicate representations of the assets in
market portfolio (M), will include all traded assets.
 This market portfolio is a value-weighted portfolio.

 This risky assets are generally thought as stocks.

 All investors hold M as their optimal risky portfolio.

 Only the amount they invest in the riskfree asset

changes.
Capital Asset Pricing Model (CAPM)

 Sharpe, W. F., “Capital Asset Prices: A Theory of Market

Equilibrium Under Conditions of Risk,” Journal of Finance
(September 1964).
The CAPM is a model for pricing an individual
security or portfolio.

 For individual securities, we make use of the

security market line  (SML) and its relation to
expected return and systematic risk (beta) to
show how the market must price individual
securities in relation to their security risk class.
FORMULA
 The risk premium on the market portfolio will be
proportional to its risk and degree of risk aversion of the
representative investor. Mathematically:

 A is the average risk aversion

 M is the optimal portfolio
 The risk Premium on individual assets will be
proportional to the risk Premium on the market
portfolio, M, and the beta coefficient of the security
relative to the market portfolio.
 Beta measures the extent to which returns on the stock
and the market move together.
Beta: A Popular Measure of
Risk
 A measure of undiversifiable risk
 Indicates how the price of a security responds to market
forces
 Compares historical return of an investment to the
market return (the S&P 500 Index)
 The beta for the market is 1.0
 Stocks may have positive or negative betas. Nearly all
are positive.
 Stocks with betas greater than 1.0 are more risky than
the overall market.
 Stocks with betas less than 1.0 are less risky than the
overall market.
Beta as a Measure of Risk

Table 5.4 Selected Betas and Associated

Interpretations
Interpreting Beta

 Higher stock betas should result in higher expected

returns due to greater risk
 If the market is expected to increase 10%, a stock with a
beta of 1.50 is expected to increase 15%
 If the market went down 8%, then a stock with a beta of
0.50 should only decrease by about 4%
 Beta values for specific stocks can be obtained from
Value Line reports or websites such as yahoo.com
 CAPM can also be shown as a graph
 Security Market Line (SML) is the “picture” of the CAPM
 We can find the SML by calculating the required return
for a number of betas, then plotting them on a graph
The Security Market Line (SML)
EXAMPLE

 If the market return is expected to be 14%,

 Beta of the stock is 1.2
 Tbill rate is 6%

 Predict the expected return for the stock?



 0.06 + 1.2 ( 0.14 – 0.06) = 0.156 ; 15.6 %

 The difference between the fair and actually expected
rate of return on a stock is called alpha, denoted by α.

 If the actual return on the last example is 17%,

 The implied alpha:

 0.17 – 0.156 = 0.014 1.4%

EXAMPLE

 What must be a beta of the portfolio with an expected

rate of return 18%, risk free rate 6% and E(RM) = 14% ?
EXAMPLE

 Assume that the price of the stock is 50$ today,

 It will pay a dividend of 6$ per share at the end of the year.
 Its beta is 1.2
 Risk free rate is 6%
 Expected rate of return on the market is 16%

 What do investors expect the stock to sell for at teh end of

the year?
 What is the expected rate of return for the stock?
 Price at the end of the year: P?

 We need to know to calculate the return for a stock wth

a dividand!

 We need CAPM formula

 ((Last price – initial price) + dividand) / Initial price=

 ((P-50) + 6)/50 = 0.06 + 1.2 (0.16 – 0.06)

 P – 50 + 6 = 50 * 0.18

 P = 53 $
 ((53-50) + 6)/50 = 0.18
Portfolio Betas

Portfolio Beta
The beta of a portfolio; calculated as the weighted
average of the betas of the individual assets the
portfolio includes
To earn more return, one must bear more risk
Only nondiversifiable risk (relevant risk) provides a
positive risk-return relationship
Portfolio Betas

Table 5.6 Austin Fund’s Portfolios V and W

Interpreting Portfolio Betas

Portfolio Betas and Associated Changes in Returns

 Reference
 Bodie, Z., Kane, A., & Marcus, A. J. Essentials of
Investments 8th Edition. McGraw-Hill.