Capital Market Theory and Asset

Pricing Models
Chapter 9

Charles P. Jones and Gerald R. Jensen,

Investments: Analysis and Management,
13th Edition, John Wiley & Sons

9-1
 Positive rather than normative
◦ Describes how investors could behave, not how
they should behave
 Focus on the equilibrium relationship between
the risk and expected return on risky assets
 Builds on Markowitz portfolio theory
 Each investor is assumed to diversify his or her
portfolio according to the Markowitz model

9-2
 Assumes all investors:  No transaction costs,
◦ Use the same no income taxes, no
information to generate inflation
an efficient frontier  No single investor
◦ Have the same one- can affect the price
period time horizon
of a stock
◦ Can borrow or lend
money at the risk-free
 Capital markets are
rate of return in equilibrium

9-3
Risk-Free Asset, Borrowing, Lending
 Risk free asset
◦ No correlation with risky assets
◦ Usually proxied by a Treasury security
 Adding a risk-free asset extends and changes
the efficient frontier
 Risk-free investing is “Lending” because
investor lends money to issuer
 With borrowing, investor no longer restricted to
personal wealth

9-4
  Risk-free asset can
L be combined with
B any portfolio in the
E(R) efficient set AB
T
◦ RF to T are lending
Z X portfolios
RF ◦ T to L are borrowing
A portfolios
 Portfolios on line RF
to L dominate all
Risk
portfolios below
9-5
 Risk-free investing and borrowing creates a
new set of risk-expected return possibilities
 Addition of risk-free asset results in:
◦ A change in the efficient set from an arc to a
straight line tangent to the original frontier
 Chosen (optimal) portfolio depends on
investor’s risk-return preferences

9-6
  Line from RF to L is
L capital market line
M (CML)
E(RM)  x = risk premium
=E(RM) - RF
x
 y = risk = 
RF
y  Slope =x/y
=[E(RM) - RF]/M
M  y-intercept = RF
Risk

9-7
 Slope of CML is the market price of risk for
efficient portfolios, or the equilibrium price
of risk in the market
 Relationship between risk and expected
return for portfolio P (Equation for CML):

E(RM )  RF
E(R p )  RF  p
M

9-8
 Most important implications of CML
◦ The portfolio of all risky assets is the optimal
risky portfolio (called the market portfolio)
◦ The expected price of risk is always positive
◦ The optimal portfolio is at the highest point
of tangency between RF and efficient frontier
◦ All investors hold the same optimal portfolio
of risky assets

9-9
 All risky assets must be in portfolio, so it is
completely diversified
◦ Includes only systematic risk
 Unobservable but approximated with
portfolio of all common stocks
◦ In turn, approximated with S&P 500
 All securities included in proportion to their
market value

9-10
 Investors use their preferences (indifference
curves) to determine optimal portfolio
 Separation Theorem
◦ The investment decision about which risky
portfolio to hold is separate from the financing
decision
 Investment decision does not involve investor
 Financing decision depends on investor’s
preferences

9-11
1. How do you determine the expected
return for individual securities or
undiversified portfolios?
2. How do investors determine the risk a
security will add to their portfolio?

* Solution is achieved by assuming investors

hold well-diversified portfolios
 CML only applies to markets in equilibrium
and efficient portfolios
 The security market line (SML) depicts
tradeoff between risk and expected return
for individual securities and portfolios
 Under CAPM, all investors hold the market
portfolio
◦ Relevant risk of any security is, therefore, its
covariance with the market portfolio

9-13
Beta – What does it tell us?
 Standardized measure of systematic risk
 Relative measure of risk: risk of an
individual stock relative to the market
portfolio of all stocks
 Relates an asset’s covariance with the
market portfolio to the variance of the
market portfolio
Covi, M
 2
M
9-14
 Indicates the risk an asset will add to a well-
diversified portfolio
 Measures an asset's nondiversifiable risk
 The slope of the line formed when as asset’s
returns are regressed against the market return
 A measure of the sensitivity of an asset’s returns to
changes in the market return
 Is the relevant risk measure for well-diversified
investors
 Beta > 1; security moves with the market only
more, security is riskier than average
 0 < Beta < 1; security moves with the market
only less
 Beta < 0; security moves counter to the market
 Market beta equals 1
 Portfolio beta is a weighted average of
individual stock betas
 Company Beta
Amazon 1.35
McDonald’s 0.72
Kellogg Company 0.64
Biogen 0.59
Wal-Mart 0.87
FirstEnergy 0.30
ConocoPhillips 0.74
Delta Air Lines 1.29
Goldman Sachs 1.35
Newmont Mining -0.03
Tiffany & Co. 2.01
 Required rate of return on asset (ki) is
composed of
◦ Risk-free rate (RF )
◦ Risk premium (i [ E(RM) - RF ] )
 Risk premium adjusted for specific security

ki = RF + i [ E(RM) - RF ]
◦ The greater the systematic risk, the greater
the required return

9-18
Beta and the SML/CAPM

 Beta = 1.0 equal risk

E(R) SML to market (average)
A
kM B
 Securities A and B are
more risky than the
C
kRF market
◦ Beta > 1.0
 Security C is less
0 0.5 1.0 1.5 2.0
Beta risky than the market
◦ Beta < 1.0

9-19
 Treasury bond rate used to estimate RF
 Expected market return unobservable
◦ Often estimated using past market returns
and taking a mean value
 Estimating security betas is difficult
◦ Beta is only company-specific factor in CAPM
◦ Beta estimation requires asset-specific
forecast

9-20
 SML
ABC
E(R) •

E(Rm)
LMN
•
XYZ
• Rrf

-0.2 0.8 1.0 1.2 eta

 Higher risk assets require higher returns
 Investors are only compensated for bearing
non-diversifiable risk
 Asset prices are not impacted by diversifiable
risk
 Undiversified investors have an inferior risk-
expected return trade-off
 Investors determine the risk they bear; market
determines their compensation
 Market model
◦ Relates a stock’s return to the return on the
market, assumes a linear relationship
◦ Produces an estimate of return for any stock
Ri =i +i RM +ei
 Characteristic line
◦ Line fit to a security’s return relative to the
market index

9-23
 RMSFT,t • • •
• •
• • Slope = rise ÷ run
= Beta
• •
MSFT •
• • •
• RMKT,t
•

Characteristic Line •
• •
 Betas change with a company’s situation
 Estimating a future beta
◦ May differ from the historical beta
 RM represents the total of all marketable
assets in the economy
◦ Approximated with a stock market index
◦ Approximates return on all common stocks

9-25
 Methods for estimating beta vary by time
period, market index, return interval, etc.
◦ Therefore, estimates of beta vary
 Regression estimates of true  and  from
the characteristic line are subject to error
 Portfolio betas more reliable than individual
security betas

9-26
Tests of CAPM
 Assumptions are mostly unrealistic
 Empirical evidence has not led to consensus
 Points widely agreed upon
◦ SML (CAPM) appears to be linear
◦ Intercept is generally higher than RF
◦ Slope of SML is generally less than theory
predicts
◦ It is likely that only systematic risk is
rewarded

9-27
 Based on Law of One Price
◦ Two assets with identical future cash flow
streams cannot sell at different prices
◦ Equilibrium prices adjust to eliminate all
arbitrage opportunities
 Unlike CAPM, APT does not assume
◦ Single-period investment horizon, absence of
taxes, riskless borrowing or lending, mean-
variance decisions

9-28
 APT assumes returns generated by a factor
model that allows for more than 1 factor
 Factor Characteristics
◦ Each risk must have a pervasive influence on
stock returns
◦ Risk factors must influence expected return
and have non-zero prices
◦ Risk factors must be unpredictable to the
market

9-29
 Most important are the deviations of the
factors from their expected values
◦ Expected return is directly related to sensitivity
◦ CAPM assumes only risk is sensitivity to market
 Expected return-risk relationship for the APT
can be described as:
E(Ri) =RF +bi1 (factor 1 risk premium) +bi2 (factor
2 risk premium) +…+bin(factor n risk premium)

9-30
 Risk factors are not specified ex ante
◦ To implement APT model, need factors that
account for differences in security returns
 CAPM identifies market portfolio as single factor

 Studies suggest certain factors are reflected in

security returns
 Both CAPM and APT rely on unobservable
expectations

9-31
Copyright 2016 John Wiley & Sons, Inc.

All rights reserved. Reproduction or translation of

this work beyond that permitted in section 117 of
the 1976 United States Copyright Act without
express permission of the copyright owner is
unlawful. Request for further information should be
addressed to the Permissions Department, John
Wiley & Sons, Inc. The purchaser may make back-
up copies for his/her own use only and not for
distribution or resale. The Publisher assumes no
responsibility for errors, omissions, or damages
caused by the use of these programs or from the
use of the information herein.

9-32