Lecture 3.2: The Capital Asset Pricing Model: Assumptions and Derivation

Today Assumptions Derivation
Lecture 3.2: The Capital Asset Pricing Model:

Assumptions and Derivation
Investment Analysis
Fall, 2012
Anisha Ghosh
Tepper School of Business
Carnegie Mellon University
November 15, 2012
Agenda
Assumptions that lead to the basic version of the CAPM
Derivation of the CAPM
Assumptions
Individual investors are price-takers: they cannot affect security prices
by their buying or selling actions (perfect competition).
Myopic behavior: All investors plan for one identical holding period
(ignore everything that might happen after the end of the single period
horizon)
All investors are rational mean-variance optimizers, i.e. they make
decisions solely on the basis of expected returns and standard
deviations of the returns in their portfolio.
Homogeneous Expectations: All investors are assumed to have
identical expectations with respect to the necessary inputs to the
portfolio decision
Investors pay no taxes on returns and no transaction costs
(commissions and service charges) on trades in securities.
Assumptions
horizon)
portfolio decision
Assumptions
horizon)
portfolio decision
Assumptions
horizon)
portfolio decision
Assumptions
horizon)
portfolio decision
Assumptions contd.
Assets are innitely divisible investors can take any position in an
investment (e.g., buy one dollars worth of IBM stock)
Unlimited short sales are allowed.
Investors can borrow or lend unlimited amounts at the riskless rate.
All assets are marketable all assets, including human capital, can
be bought and sold on the market.
Assumptions contd.
Assumptions contd.
Assumptions contd.
The Efcient Frontier - No Lending and Borrowing
BC represents the efcient frontier while ABC represents the set of
minimum variance portfolios facing an individual investor i
Note: In general, investors may have different expectations the
efcient frontier will differ among investors
If the investor can also borrow or lend unlimited amounts at the riskless
rate R
F
the tangency portfolio P
i
is investor i s optimal portfolio of
risky assets, regardless of his risk preferences
rate R
F
i
rate R
F
i
rate R
F
i
CAPM: Derivation
If all investors have homogeneous expectations and they all face the
same R
F
they will each face the same investment opportunity set
all investors would buy the same portfolio P
i
of risky assets and then
borrow or lend to achieve the risk-return combination they prefer.
Since every investor is holding the same portfolio P
i
of risky assets, and
every asset must be held by someone, P
i
can only be the market
portfolio: the portfolio composed of all risky assets held according to
their relative market values.
Market Portfolio
The market portfolio is a portfolio comprised of all risky assets where
each asset is held in the proportion that the market value of that asset
represents of the total market value of all risky assets.
CAPM: Derivation
same R
F
i
i
i
Market Portfolio
CAPM: Derivation
same R
F
i
i
i
Market Portfolio
CAPM: Derivation
same R
F
i
i
i
Market Portfolio
CAPM: Derivation
same R
F
i
i
i
Market Portfolio
Capital Market Line
The straight line in the above gure is referred to as the Capital Market
Line (CML).
The CML can be described by the equation:
E (R
e
) = R
F
price of time
+
E (R
M
) R
F
M

market price of risk
amount of risk
The CML gives the trade-off between risk and return for efcient
portfolios.
Individual securities will typically be inefcient, and will not lie on the
CML.
The CAPM answers the question, "How can we adapt the CML to work
for ANY asset, not just efcient portfolios?"
Capital Market Line
Line (CML).
E (R
e
) = R
F
price of time
+
E (R
M
) R
F
M

amount of risk
portfolios.
CML.
Capital Market Line
Line (CML).
E (R
e
) = R
F
price of time
+
E (R
M
) R
F
M

amount of risk
portfolios.
CML.
Capital Market Line
Line (CML).
E (R
e
) = R
F
price of time
+
E (R
M
) R
F
M

amount of risk
portfolios.
CML.
Capital Market Line
Line (CML).
E (R
e
) = R
F
price of time
+
E (R
M
) R
F
M

amount of risk
portfolios.
CML.
The CAPM
For very well-diversied portfolios, nonsystematic risk tends to go to
zero and the only relevant risk is systematic risk measured by Beta.
Given the assumptions of homogeneous expectations and unlimited
riskless borrowing and lending, all investors will hold the market
portfolio.
the investor will hold a very well-diversied portfolio.
Beta is the correct measure of a securitys risk.
Since we assume that the investor is concerned only with expected
return and risk, the only dimensions of a security that need be of
concern are expected return and Beta.
The CAPM
portfolio.
The CAPM
portfolio.
The CAPM
portfolio.
The CAPM
portfolio.
The CAPM: Derivation
All investments and portfolios of investments must lie along a straight
line in the expected return-Beta space:
E (R
p
) = XE (R
A
) + (1 X) E (R
B
)

p
= X
A
+ (1 X)
B
E (R
p
) = a + b
p
If any investment were to lie above or below that straight line, then an
opportunity would exist for riskless arbitrage.
This arbitrage would continue until all investments converged to the line.
How do we identify this straight line?
E (R
p
) = XE (R
A
) + (1 X) E (R
B
)

p
= X
A
+ (1 X)
B
E (R
p
) = a + b
p
E (R
p
) = XE (R
A
) + (1 X) E (R
B
)

p
= X
A
+ (1 X)
B
E (R
p
) = a + b
p
E (R
p
) = XE (R
A
) + (1 X) E (R
B
)

p
= X
A
+ (1 X)
B
E (R
p
) = a + b
p
The CAPM: Derivation contd.
A straight line can be identied using any two points.
One of the points is the market portfolio, M that has a Beta of 1.
The second point corresponds to the riskless asset that has Beta of 0
the CAPM is given by the equation:
E (R
i
) = R
F
+
i
[E (R
M
) R
F
]
i
=

iM
2
M
E (R
i
) = R
F
+
i
[E (R
M
) R
F
]
i
=

iM
2
M
E (R
i
) = R
F
+
i
[E (R
M
) R
F
]
i
=

iM
2
M
E (R
i
) = R
F
+
i
[E (R
M
) R
F
]
i
=

iM
2
M
What is the Market Portfolio
The market portfolio is the aggregate of all risky investments including:
Stocks
Bonds
Real Estate
Human Capital, ...
Baseline: hard to measure
Proxies:
Dow: "Price-weighted" index of returns on 30 large "blue chip"
companies adjusted for stock splits and dividends
S&P 500 index
Stocks
Bonds
Real Estate
Human Capital, ...
Proxies:
S&P 500 index
Stocks
Bonds
Real Estate
Human Capital, ...
Proxies:
S&P 500 index

Lecture 3.2: The Capital Asset Pricing Model: Assumptions and Derivation

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