Asset Pricing Theories

• Asset pricing theories try to explain the expected

rates of return of assets and why they differ both
among each other and over time.

• Equilibrium Rates of Return

A market is in equilibrium when all investors hold
their optimal portfolio and hence there is no reason
for further transactions.
 Capital Asset Pricing Model
• Focus on the equilibrium relationship between
the risk and expected return on risky assets

• It provides a way to calculate expected return based

on its level of systematic risk, as measured by beta.

• It is the equilibrium model that underlies all modern

financial theory.

• Derived using principles of diversification with

simplified assumptions.
Characteristics of the Market Portfolio

• All risky assets must be in portfolio, so it is

completely diversified
• Contains only systematic risk
• All securities included in proportion to their
market value
• Unobservable, but proxied by Ghana All Share
Composite Index
• In theory, it should contain all risky assets
worldwide
 Capital Market Line: slope and
market risk premium

• Line from RF to L is capital

L market line (CML)
• x = risk premium
M
E(RM) = E(RM) - RF
• y = risk = M
x
• Slope = x/y
RF = [E(RM) - RF]/M
y
• y-intercept = RF
M
Risk
Capital Market Line
• Slope of the 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(R M )  RF
E(R p )  RF  p
M
Question
An analyst estimates that the expected returns
on the market (S&P/TSX Composite Index) is 12
per cent, with a standard deviation of 15 per
cent, and the risk-free rate of return (Treasury
bill rate) is at 5 per cent. Using the following
information about the variance of returns of
some efficient portfolios, calculate their expected
returns using the Capital Market Line approach.
• Efficient Portfolio Variance
• Portfolio A 121
• Portfolio B 144
• Portfolio C 196
Security Market Line
• CML Equation only applies to markets in equilibrium
and efficient portfolios
• The Security Market Line depicts the tradeoff
between risk and expected return for individual
securities
• Under CAPM, all investors hold the market portfolio
• How does an individual security contribute to the risk of
the market portfolio?
The Capital Asset Pricing Model (CAPM)
• RISK AVERSE INVESTORS
• Risk averseness implies that investors
 Prefer sure return to same expected return which is uncertain.
 Demand risk premium if return is uncertain.
 Seek risk reduction through diversification.

• Assumptions of CAPM
 Investors are expected wealth maximizers who look at
mean and standard deviation of portfolio returns.
 Investors can borrow or lend an unlimited amount at risk- free
rate.
 Investors have homogeneous expectations about expected
returns and risks.
 Frictionless markets with no taxes.
Security Market Line

• Equation for expected return for an individual stock

similar to CML Equation

E(R M )  RF  i,M
E(R i )  RF 
M M
 RF   i E(R M )  RF
 Security Market Line

• Beta = 1.0 implies as risky

as market
SML
• Securities A and B are
E(R)
more risky than the market
A • Beta > 1.0
E(RM) B • Security C is less risky than
C the market
RF • Beta < 1.0

0 0.5 1.0 1.5 2.0

BetaM
Security Market Line
• Beta measures systematic risk
• Measures relative risk compared to the market portfolio
of all stocks
• Volatility different than market
• All securities should lie on the SML
• The expected return on the security should be only that
return needed to compensate for systematic risk
SML and Asset Values
Er
Underpriced SML: Er = rf +  (Erm – rf)

Overpriced

rf
β

Underpriced  expected return > required return according to CAPM

 lie “above” SML
Overpriced  expected return < required return according to CAPM
 lie “below” SML
Correctly priced  expected return = required return according to CAPM
 lie along SML
The SML and a Positive-Alpha Stock:
Disequilibrium example

• Suppose a security with a 

of 1.2 is offering expected
return of 17%
• According to SML, it should
be 14.8%
• Under-priced: offering too
high of a rate of return for
its level of risk
• Its alpha is 17-14.8 = 2.2%
CAPM’s Expected Return-Beta
Relationship
• Required rate of return on an asset (ki) is
composed of
• risk-free rate (RF)
• risk premium (i [ E(RM) - RF ])
• Market risk premium adjusted for specific security

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