ECO 505

T
HOW TO PRICE/VALUE RISKY
ASSETS:
The Capital Asset Pricing Model
 Main Readings
• Howells & Bain (2008: 192-195)
• Elton & Gruber (2014)
 INTRODUCTION
• How do we use the relationships studied so far to
determine the value/price of an asset?
• In particular: How do we put a price/premium on risk?
• Portfolio theory has illustrated the risk/ return relationship
between the assets in the market, but we do not know yet
how to price/value an individual asset.
• But we have measured risk as the “total” degree of
volatility of asset returns.
• To do that, we need the CAPM
• First we need to revisit Market and Specific Risk
 REVISITING MARKET &
SPECIFIC RISK
• Total risk = Market Risk + Specific Risk =
Standard Deviation
• However, diversification can reduce total risk by
eliminating specific risk
• BUT, market risk remains, therefore:
• Standard Deviation (measuring total risk) is an
over-statement of the risk faced by the rational,
risk-averse investor.
• So: how do we measure the relevant risk of an
asset and how do we price an asset?
 THE CAPM

• The Rate of Return on an Asset will be

equal to the Risk-free Rate of Return plus
a Risk-Premium which depends on the
Market Price of Risk and the Quantity of
Market Risk contained within the Asset
 ELEMENTS OF THE CAPM:
The Risk Free Return
• Risk free return, eg on Government Bonds.
Effectively forms a floor or threshold under the
return of all risky assets. Expect a constant
risk-premium above the risk-free rate.
• If the risk free rate rises, expect returns on
risky assets to rise with it, but this is not always
the case in practice.
• The Risk-free rate is denoted by Krf
 ELEMENTS OF THE CAPM:
The Market Price of Risk
• A portfolio which replicates the whole market portfolio
of risky assets
• Means practically to (1) have all these assets in the
portfolio and (2) in the same proportion as they exist in
the whole market.
• Could view this as the return for example on the all
share index (eg ALSI 40). Denote by Km
• Then Km –Krf constitutes the market risk premium or
market price of risk.
• This becomes the “benchmark” against which we can
judge the premium to be paid on individual assets
 ELEMENTS OF THE CAPM
The Beta Coefficient
• Now need to find out how the returns on an individual
asset compares with the market as a whole, ie, compare
the variance of returns of both
• Scatter plot of returns of the individual asset and
market as a whole.
• Slope of the fitted regression line shows the variation of
returns of individual asset compared to that of market
as a whole.
• Eg if 45 degrees, the individual asset has the same
exposure to market risk than the whole market
portfolio
• Beta coefficient = change in Ki/change in Km, eg if
slope of line is 45 degrees, Beta = 1.
THE BETA COEFFICIENT
 CALCULATING THE BETA
COEFFICIENT

 ( R  Rit )( Rmt  Rmt )

60

 im it
i  2  t 1

m 60

 (R
t 1
mt  Rmt ) 2
 CALCULATING THE BETA
COEFFICIENT

 5



 ( R i  Ri ) ( Rm  Rm ) 

/ 5
i  t 1
5

 ( Rm  Rm ) / 5
t 1
2
 CALCULATING BETA: AN EXAMPLE (Elton &
Gruber, 2011: pp 140-141)

Month Stock Return Market Return Value

Minus Mean Minus Mean
1 (10-8) X (4-4) = 0
2 (3-8) X (2-4) = 10
3 (15-8) X (8-4) = 28
4 (9-8) X (6-4) = 2
5 (3-8) X (0-4) = 20
Total 60

 m2  (4  4) 2  (2  4) 2  (8  4) 2  (6  4) 2  (0  4) 2 / 5  8
 SUMMARY OF THE EXAMPLE:
Calculating Beta
• The covariance is 60/5 = 12.
• The variance of the market return is the
average of the sum of squared deviation
from the mean = 8
• Thus Beta = 12/8 = 1.5
• The asset is therefore more risky than the
market average
 THE CAPM EQUATION

ˆ
K A  K rf   A ( K m  K rf )
THE SECURITY MARKET LINE
 VALUE/USE OF THE CAPM
• SML shows the additional return (above
Krf) required on an individual asset of
which the risk characteristics can be
compared with the whole market.
• “Message” of the CAPM is that assets
which are fairly priced will yield a return
such that they plot on the SML.
 VALUE/USE OF THE CAPM
• An asset with no relevant risk (Beta = 0) has a
required rate of return = risk free rate.
• An asset with Beta = 1 has the same required rate
of return as the whole market portfolio.
• What can cause changes in the required rate of
return?
• Now need to distinguish between movements
along the SML and shifts of the SML itself.
 VALUE/USE OF THE CAPM
• Movements along the SML:
• The SML plots the required rate of return as a function of
Beta, so movements along the curve will occur whenever
something affects a share’s Beta coefficient.
• This means that exposure to the market (market risk) has
changed.
• An increase in exposure will move us up along the curve,
increasing the required rate of return.
• Reductions in risk move us down the SML, lowering the
required rate of return.
 VALUE/USE OF THE CAPM
• Shifts in the SML itself:

• The SML itself can change in two ways: a change in slope

or a parallel shift.
• Change in slope can occur if there is a change in risk
aversion.
• An increase would mean the risk premium and the slope
would increase.
• The required rate of return on assets also increases, seeing
that risk itself is now priced higher.
 VALUE/USE OF THE CAPM
• The SML can also change its position by a parallel
shift. This will happen if the risk free rate changes
cet par.
• The required rate of return then moves in the same
direction.
• Finally, work through the example on p.194 on
how the CAPM enables us to convert the required
rate of return to the price of the asset.