FIN 435

Capital Asset
Pricing Model
Capital Asset Pricing Model (CAPM)

• The relationship between beta and expected return is

the essence of the capital asset pricing model
(CAPM), which states that a security’s expected return
is a linear function of its beta.

E R   R f  *E Rm  R f 
where R f = risk - free rate
R = return on security x
Rm = return on the market
 = beta of security x
• The capital asset pricing model (CAPM) is
a theoretical description of the way in
which the market prices investment assets.

• The capital asset pricing model deals with

expectations about the future.
Security Market Line (SML)

• The graphical relationship between expected

return and beta is the security market line (SML)

Expected Return

E(R)
Market Portfolio

Rf

1.0 Beta
• Beta = 1.0, market portfolio’s risk
• Beta > 1.0, riskier than market portfolio
• Beta < 1.0, less risky than market portfolio

• Beta obviously measures risk, but what kind

of risk?
Two types of risk

• Systematic risk is the risk that remains after

no further diversification benefits can be
achieved
• Unsystematic risk is the part of total risk
that is unrelated to overall market
movements and can be diversified
– Research indicates up to 75 percent of total risk is
diversifiable
• Investors are rewarded only for systematic
risk
– Rational investors should always diversify
– Explains why beta (a measure of systematic risk)
is important
• Securities are priced on the basis of their beta
coefficients
• Portfolio variance (total risk) declines as the
number of securities included in the portfolio
increases
– On average, a randomly selected ten-security
portfolio will have less risk than a randomly
selected three-security portfolio
– Risk-averse investors should always diversify to
eliminate as much unsystematic risk as possible
Diversification

• Increasing the number of portfolio

components provides diminishing benefits as
the number of components increases
– Adding a security to a one-security portfolio
provides substantial risk reduction
– Adding a security to a twenty-security portfolio
provides only modest additional benefits
• Beta measures systematic risk
– Diversification does not mean to reduce beta
– Investors differ in the extent to which they will
take risk, so they choose securities with different
betas
• e.g., an aggressive investor could choose a portfolio
with a beta of 2.0
• e.g., a conservative investor could choose a portfolio
with a beta of 0.5
• Unsystematic risk can be diversified and is
irrelevant

• Systematic risk cannot be diversified and is

relevant
– Measured by beta
• Beta determines the level of expected return on a
security or portfolio (SML)
Diversification, Beta and CAPM

• The more systematic risk you carry, the

greater the expected return.

E R   R f  *E Rm  R f 
where R f = risk - free rate
R = return on security x
Rm = return on the market
 = beta of security x
Stock valuation
Stock valuation methods
 Dividend discount model
 Price-earnings (PE) method
 Adjusted dividend discount model
 Capital asset pricing model (CAPM)
Discounted Cash Flow (DCF) models
 Intrinsic value of a security is

Cash Flowsn
Value of sec urity   t
t 1 ( 1  k)

where k = discount rate

Dividend Discount Model (DDM)
 Current value of a share of stock is the discounted value
of all future dividends

D1 D2 D
P  1
 2
 ... 
(1  k) (1  k) (1  k)
 Dt
 t
t 1 ( 1  k)

where k = discount rate

Zero-growth rate model
 The price of a stock should reflect the present value of the
stock’s future dividends (John Williams, 1931).
 For a constant dividend:

D
Price 
k
Constant growth-rate model
 The price of a stock should reflect the present value of the
stock’s future dividends (John Williams, 1931).

 For a constantly growing dividend:

D1
Price 
kg
where g = dividend growth rate
Dividend discount model
 A firm is expected to pay a dividend of $2.10 per share
every year in the foreseeable future.

 Investors require a return of 15% on the firm’s stock.

 According to the dividend discount model, what is a fair

price for the firm’s stock?
Dividend discount model
D
Price 
k

$2.10

15%

 $14
Dividend discount model
 A firm is expected to pay a dividend of $2.10 per share in
one year.
 In every subsequent year, the dividend is expected to
grow by 3 percent annually.
 Investors require a return of 15% on the firm’s stock.

According to the dividend discount model, what is a fair

price for the firm’s stock?
Dividend discount model
D
Price 
kg

$2.10

15%  3%

 $17.50
Price-earnings (PE) method
 Assigns the mean PE ratio based on expected earnings of
all traded competitors to the firm’s expected earnings for
the next year
 Valuation per share
= Expected earnings of firm/share X Mean industry PE ratio
Price-earnings (PE) method
 A firm is expected to generate earnings of $2 per share
next year.

 The mean ratio of share price to expected earnings of

competitors in the same industry is 14.

 What is the valuation of the firm’s shares according to the

PE method?
Price-earnings (PE) method
 Valuation per share
= Expected earnings of firm/share X Mean industry PE ratio
= $2/share X 14
= $28
Adjusted dividend discount model
 Forecasted earnings in n years
= E (1 + G)n

 Price per share in n years

= Expected earnings of firm/share X Mean industry PE ratio

 The value of the stock is:

 The PV of the future dividends over the investment horizon
 The PV of the forecasted price at which the stock will be sold
Adjusted dividend discount model
 Kimye Corp. currently has earnings of $10 per share.
 Investors expect that the EPS will grow by 3 percent per
year and expect to sell the stock in four years.
 Other firms in Kimye’s industry have a mean PE ratio of
7.
 Kimye is expected to pay a dividend of $2 per share over
the next four years. Investors require a return of 13% on
their investment.
What is a fair value of the stock according to the adjusted
dividend discount model?
Adjusted dividend discount model
 Forecasted earnings in 4 years
= E (1 + G)n
= $10 (1 + 0.03)4
= $11.26
 Stock price in 4 years
= Earnings in 4 years X Mean industry PE ratio
= $11.26 X 7
= $78.82

 Fair value of the stock

$2 $2 $2 $2 $78.82
    
(1.13) (1.13) (1.13) (1.13) (1.13) 4
1 2 3 4

 $54.29
Capital asset pricing model (CAPM)
 Suggests that the return on an asset is influenced by the
prevailing risk-free rate, the market return and beta

R j  Rf  B j ( R m  Rf )
Capital asset pricing model (CAPM)
 The yield on newly issued T-bonds is commonly used as
a proxy for the risk-free rate
 The market risk premium can be determined using
historical data over 30 or more years
 Beta reflects the sensitivity of the stock’s return to the
market’s overall return
 Beta is typically measured with monthly or quarterly
data over the last four years or so

R j  Rf  B j ( R m  Rf )
Capital asset pricing model (CAPM)
 Tyrion Corp. has a beta of 1.7.
 The prevailing risk-free rate is 5% and the market risk
premium is 5%.

 What is the required rate of return of Tyrion Corp.

according to the CAPM?
Capital asset pricing model (CAPM)

R j  Rf  B j ( R m  R f )
 5%  1.7(10%  5%)
 13.5%
Stock performance measurement
 Sharpe ratio
 Is the reward-risk ratio
 is appropriate when total variability is thought to be the
appropriate measure of risk
 The higher the stocks’ mean return relative to the mean risk-free
rate and the lower the standard deviation, the higher the Sharpe
index

R  Rf
Sharpe index 

Stock performance measurement
 Sharpe ratio
 Tywin Co’s stock has an average return of 15% and an average
standard deviation of 13%.
 The average risk-free rate is 8%.

 What is the Sharpe index for Tywin’s stock?

R  Rf
Sharpe index 

Stock performance measurement
 Sharpe ratio
 Tywin Co’s stock has an average return of 15% and an average
standard deviation of 13%.
 The average risk-free rate is 8%.

 What is the Sharpe index for Tywin’s stock?

R  Rf
Sharpe index 

15%  8%
  0.54
13%
Stock performance measurement
 Treynor ratio
 Is appropriate when beta is thought to be the most appropriate
type of risk
 The higher the Treynor index, the higher the return relative to the
risk-free rate, per unit of risk

R  Rf
Treynor index 
B
Stock performance measurement
 Treynor ratio
 Eddard Inc’s stock has an average return of 15% and a beta of 1.8.
 The average risk-free rate is 8%.

 What is the Treynor index for Eddard Inc’s stock?

R  Rf
Treynor index 
B
Stock performance measurement
 Treynor ratio
 Eddard Inc’s stock has an average return of 15% and a beta of 1.8.
 The average risk-free rate is 8%.

 What is the Treynor index for Eddard Inc’s stock?

R  Rf
Treynor index 
B
15%  8%
  0.04
1.8
Common stocks: Analysis and strategy
Impact of the market
– Pervasive and dominant
– The single most important risk affecting the price movement of
common stocks
– Particularly true for a diversified portfolio of stocks
–Accounts for 90% of the variability in a diversified portfolio’s return
– Investors buying foreign stocks face the same situation
Required rate of return
– Minimum expected rate of return needed to induce investment
– Given risk, a security must offer some minimum expected
return to persuade purchase
– Required RoR = RF + Risk premium
– Investors expect the risk free rate as well as a risk premium to
compensate for the additional risk assumed
Security market line (SML)
– Beta = 1.0 implies as risky as market
– Securities A and B are more risky than the market
Beta >1.0
– Security C is less risky than the market
Beta <1.0 SML
E(R)

A
kM B
C
kRF

0 0.5 1.0 1.5 2.0

BetaM
Understanding the required rate of return
– Risk-free rate
– RF =Real RoR +Inflation premium
– Real rate of return is basic exchange rate in the economy
– Nominal RF must contain premium for expected inflation
–The risk premium
– Reflects all uncertainty in the asset
Passive stock strategies
– Natural outcome of a belief in efficient markets
– No active strategy should be able to beat the market on a risk adjusted basis
– Emphasis is on minimizing transaction costs and time spent in
managing the portfolio
– Expected benefits from active trading or analysis less than the costs
Passive stock strategies
– Buy-and-hold strategy
– Belief that active management will incur transaction costs and involve
inevitable mistakes
– Important initial selection needs to be made
– Functions to perform: reinvesting income and adjusting to changes in risk
tolerance
Passive stock strategies
– Index funds
– Mutual funds designed to duplicate the performance of some market index
– No attempt made to forecast market movements and act accordingly
– No attempt to select under- or overvalued securities
– Low costs to operate, low turnover
Active stock strategies
– Assumes the investor possesses some advantage relative to
other market participants
– Most investors favor this approach despite evidence about efficient markets
– Identification of individual stocks as offering superior return-
risk tradeoff
– Selections part of a diversified portfolio
Active stock strategies
– Majority of investment advice geared to selection of stocks
– Value Line Investment Survey
– Security analyst’s job is to forecast stock returns
– Estimates provided by analysts
expected change in earnings per share, expected return
on equity, and industry outlook
– Recommendations: Buy, Hold, or Sell
Sector rotation
– Similar to stock selection, involves shifting sector weights in
the portfolio
– Benefit from sectors expected to perform relatively well and de-emphasize
sectors expected to perform poorly
– Four broad sectors:
– Interest-sensitive stocks, consumer durable stocks, capital goods stocks, and
defensive stocks
Market timing
– Market timers attempt to earn excess returns by varying the
percentage of portfolio assets in equity securities
– Increase portfolio beta when the market is expected to rise
– Success depends on the amount of brokerage commissions and
taxes paid
– Can investors regularly time the market to provide positive risk-adjusted
returns?
Efficient markets and active strategies
– If EMH true:
– Active strategies are unlikely to be successful over time after all costs
–If markets efficient, prices reflect fair economic value
– EMH proponents argue that little time should be devoted to
security analysis
– Time spent on reducing taxes, costs and maintaining chosen portfolio risk
Efficient market hypothesis (EMH)
Efficient markets
– How well do markets respond to new information?
– Should it be possible to decide between a profitable and
unprofitable investment given current information? How should
investors select the best risky portfolio?
– Efficient Markets
The prices of all securities quickly and fully reflect all available information
Conditions for an efficient market
– Large number of rational, profit-maximizing investors
– Actively participate in the market
– Individuals cannot affect market prices
– Information is costless, widely available, generated in a
random fashion
– Investors react quickly and fully to new information
Consequences of efficient market
– Quick price adjustment in response to the arrival of random
information makes the reward for analysis low
– Prices reflect all available information
– Price changes are independent of one another and move in a
random fashion
– New information is independent of past
Forms of market efficiency
– Efficient market hypothesis
– To what extent do securities markets quickly and fully reflect different
available information?
– Three levels of Market Efficiency
– Weak form - market level data
– Semistrong form - public information
– Strong form - all (nonpublic) information
Weak form
– Prices reflect all past price and volume data
– Technical analysis, which relies on the past history of prices, is
of little or no value in assessing future changes in price
– Market adjusts or incorporates this information quickly and
fully
Semistrong form
– Prices reflect all publicly available information
– Investors cannot act on new public information after its
announcement and expect to earn above-average, risk-adjusted
returns
– Encompasses weak form as a subset
Strong form
– Prices reflect all information, public and private
– No group of investors should be able to earn abnormal rates of
return by using publicly and privately available information
– Encompasses weak and semistrong forms as subsets
Evidence on market efficiency
– Keys:
– Consistency of returns in excess of risk
– Length of time over which returns are earned
– Economically efficient markets
– Assets are priced so that investors cannot exploit any discrepancies and
earn unusual returns
– Transaction costs matter
Weak form evidence
– Test for independence (randomness) of stock price changes
– If independent, trends in price changes do not exist
– Overreaction hypothesis and evidence
– Test for profitability of trading rules after brokerage costs
– Simple buy-and-hold better
Semistrong form evidence
– Empirical analysis of stock price behavior surrounding a
particular event
– Examine company unique returns
 The residual error between the security’s actual return and that given by
the index model
 Abnormal return (Arit) =Rit - E(Rit)
 Cumulative when a sum of Arit
Semistrong form evidence
– Stock splits
 Implications of split reflected in price immediately following the
announcement
– Accounting changes
 Quick reaction to real change in value
– Initial public offerings
 Only issues purchased at offer price yield abnormal returns
– Announcements and news
 Little impact on price after release
Strong form evidence
– Test performance of groups which have access to nonpublic
information
 Corporate insiders have valuable private information
 Evidence that many have consistently earned abnormal returns on their
stock transactions
– Insider transactions must be publicly reported
Implications of efficient market hypothesis
– What should investors do if markets efficient?
– Technical analysis
 Not valuable if weak form holds
– Fundamental analysis of intrinsic value
 Not valuable if semistrong form holds
 Experience average results
Implications of efficient market hypothesis
For professional money managers

– Less time spent on individual securities

 Passive investing favored
 Otherwise must believe in superior insight
– Tasks if markets informationally efficient
 Maintain correct diversification
 Achieve and maintain desired portfolio risk
 Manage tax burden
 Control transaction costs
Market anomalies
– Exceptions that appear to be contrary to market efficiency
– Earnings announcements affect stock prices
 Adjustment occurs before announcement but significant amount after
 Contrary to efficient market because the lag should not exist
Market anomalies
– Low P/E ratio stocks tend to outperform high P/E ratio stocks
 Low P/E stocks generally have higher risk-adjusted returns
 But P/E ratio is public information
– Should portfolio be based on P/E ratios?
 Could result in an undiversified portfolio
Market anomalies
– Size effect
 Tendency for small firms to have higher risk-adjusted returns than large
firms
– January effect
 Tendency for small firm stock returns to be higher in January
 Of 30.5% size premium, half of the effect occurs in January
Behavioral finance
– Rationality as a principle of behavior
– Are there systematic deviations from the norms of rationality?
– How do human beings make decisions?
 Distortion throughout the process of decision-making
 Marriage of psychology and finance
Conclusions about market efficiency
– Support for market efficiency is persuasive
 Much research using different methods
 Also many anomalies that cannot be explained satisfactorily
– Markets very efficient but not totally
 To outperform the market, fundamental analysis beyond the norm must
be done
Conclusions about market efficiency
– If markets operationally efficient, some investors with the skill
to detect a divergence between price and semistrong value earn
profits
 Excludes the majority of investors
 Anomalies offer opportunities
– Controversy about the degree of market efficiency still remains