Econ331

Financial Economics

University of Wollongong
Spring 2016
 Lecture 7

Capital Asset Pricing Model

(FNZ Ch14)
 Portfolio Theory and CAPM
• Capital Asset Pricing Model (CAPM) is based on the
Portfolio Theory (PT) that we have studied
• PT is prescriptive
• It shows how one should construct a portfolio of assets if one wants to
achieve an optimal combination of risk and return
• It cannot (and is not supposed to) teach us anything about actual
investor behaviour
• CAPM, on the other hand, is descriptive
• It formalizes the relationship that should exists between asset return
and risk if investors behave in a hypothesized manner
• It does this by imposing an assumption of an equilibrium in the asset
market and deriving its implications
• Importantly it delivers testable predictions which can be tested using
available data
 Portfolio Theory and CAPM
• Capital Asset Pricing Theory (CAPM) is an extension
of the Portfolio Theory
• Harry Markowitz (1952)

• It was developed in the 1960s by

• William Sharpe (1964)
• John Lintner (1965)
• Jan Mossin (1966)
 Portfolio Theory and CAPM
• Like Portfolio Theory, CAPM assumes that investors
only care about the expected return and its variance
(that is they have mean-variance utility function)

• But it goes further by making an additional

assumption
• Asset market is assumed to be in equilibrium: demand for
financial assets is equal to the supply
• Making this assumption allows us to deriving implications
about the pricing of financial assets
 CAPM Assumptions
More precisely, CAPM imposes the following
assumptions
1) Investors have mean-variance utility
2) Investors are rational and risk-averse
3) Common time frame for all investments
4) Investors have the same expectations about the expected
return and return variance for all assets
5) Thee exists a risk-free asset and investors can borrow or
lend at the risk free rate
6) Capital markets are competitive
 Portfolio Theory and CAPM
• Consider now a asset market with one riskless and
many risky assets

• As we have seen before (The Separation Theorem),

all investors will hold some combination or the
riskless asset and the tangency portfolio T
• Recall that T is the efficient portfolio of risky assets with
the highest Sharpe ratio

• This essentially describes the demand for the risky

assets
 Portfolio Theory and CAPM
• Now we will impose the equilibrium assumption by requiring
that Demand=Supply

• Define the market portfolio as the portfolio consisting of all

existing risky financial assets
• Example: suppose that there are only two stocks, A and B
• The total market value of A is $600 and that of B is $400
• The total value of the market is $1000, and the market weight of A is
0.6, while the market weight of B is 0.4
• A market portfolio is a portfolio which invests 60% of funds in A and
40% of funds in B

• When you hold the market portfolio, you “own the market”
 Portfolio Theory and CAPM
• Key idea: in equilibrium, every investor would hold the market
portfolio of risky assets

• Suppose there are only two investors: 1 and 2

• Total funds to be invested in risky asset: I1 and I2
• Let VM be the total value of the market and Vi be the value of asset i
• Note that in equilibrium we must have I1 + I2 = VM

• Now because both investors have the same expectations, they

will both invest the same share of their funds devoted to risky
assets in asset i: wi . Therefore we must have
• wi (I1 + I2)= Vi (Demand for asset i = Supply of asset i)
 Portfolio Theory and CAPM
• Now because both investors have the same expectations, they
will both invest the same share of their funds devoted to risky
assets in asset i: wi . Therefore we must have
• wi (I1 + I2)= Vi (Demand for asset i = Supply of asset i)

• This implies that wi = Vi / (I1 + I2)= Vi / VM

• In the risky portfolio of each investor the equilibrium share of asset i
must be equal to the market share of asset I

• Now because the risky portfolio of each investor is the

Tangency Portfolio T, we conclude that
Tangency Portfolio =Market Portfolio

• In equilibrium, every investor owns the market

 Deriving CAPM
ER


T=M


rRF 

St Dev
In equilibrium, demand for risky assets (Tangency Portfolio T) must
coincide with the supply of risky assets (Market Portfolio M)

Note that this means that the Market Portfolio is efficient

 Deriving CAPM
Capital Market Line
ER


T=M


rRF 

St Dev
The CAL corresponding to the Market Portfolio is called the Capital Market Line
 Deriving CAPM
CML
U
ER

 M

rRF 

St Dev

The individually optimal portfolios combing the riskless and

risky assets are located along CML
 Deriving CAPM
Now recall that along any CAL the relationship between
risk and return is given by
rT  rRF
rP  rRF  P
T
Because T=M, along the Capital Market Line (CML) we have
rM  rRF
rP  rRF  P
M

rM  rRF
And the corresponding Sharpe ratio is called the
M
equilibrium price of risk
 Deriving CAPM
Now lest consider an arbitrary asset j, and ask the question:

If asset j is to be held by investors in equilibrium, what should be

true about its risk-return profile?

In other words, what should be the equilibrium relationship

between its expected return and standard deviation of this asset:

We will show next that CAPM implies that this relationship

should take a specific form, which describes the risk and return
characteristics of every asset in the market
 Deriving CAPM
Consider an investor who takes the part of her wealth allocated
to the risky asset and divides it further as follows: she invests a
fraction w in asset j and 1-w in the market portfolio.

Because the market portfolio already contains some amount of

asset j
• choosing w>0 implies that asset j will be overweighted in the new
portfolio relative to the market portfolio, while w<0 means that it will be
underweighted in the new portfolio.
• the weight w is not the weight of j in the new portfolio, it is rather an
additional weight which makes the proportion of asset j deviate from the
proportion it would normally have in the market portfolio
• when w=0, the new portfolio coincides with the market portfolio
 Deriving CAPM
We know that the expected return and variance of the new
portfolio P are given by

rP  wrj  (1  w)rM

 P2  w2 2j  (1  w) 2  M2  2w(1  w) jM

Where  jM is the covariance between the return on asset j and

the market return

Now we will vary the weight w to trace out the relationship

between these expected return and variance
 Deriving CAPM
As we vary the weight w we are tracing out the new risk-return
frontier corresponding to the new portfolio P

When w=0 the new frontier will pass through M because at his
point P and the market portfolio coincide

At all other points the new frontier will lie below CML. If it were
not the case, some point on the new frontier would dominate a
portion of CML and some investors would not want to hold the
market portfolio. Then the market will no longer be in the
equilibrium.
 Deriving CAPM
As we choose w close to 1 we are moving towards a portfolio
containing only j (denoted by A in the diagram)
As we choose w close to zero we are moving towards a portfolio
containing no j at all (denoted by A’ in the diagram)
 Deriving CAPM
Together all these observations imply that the new frontier must
be tangent to the CML at the point M

This of cause means that CML and the frontier have the same
slope

rM  rRF
We know that the slope of CML is
M

Now we can find the slope of the frontier, set it equal to the
slope of CML and derive the relationship between the return an
risk of asset j and the return and risk of the market
 Deriving CAPM
Recall that we are interested in the relationship between the
return and standard deviation of the new portfolio P
rP  f ( P ) (*)
More precisely, we are interested in its slope, which is the slope
of the frontier corresponding to P

f ( P )

Now lets introduce some new notation

g ( w)  rP  wrj  (1  w)rM

h( w)   P  ( w2 2j  (1  w) 2  M2  2 w(1  w) jM )1/2

 Deriving CAPM
Lets introduce some new notation
g ( w)  rP  wrj  (1  w)rM

h( w)   P  ( w2 2j  (1  w) 2  M2  2 w(1  w) jM )1/2

With this new notation we can write equation (*) as follows

g ( w)  f (h( w))

Now using the chain rule we get

g ( w)  f (h( w))h( w)  f ( P )h( w)

 Deriving CAPM
Now we can rearrange

g ( w)  f ( P )h( w)

To compute the slope of the frontier

g ( w)
f ( P ) 
h( w)

Then we can evaluate this expression at w=0 to get the slope of

the frontier at point M
 Deriving CAPM
We have
g ( w)  wrj  (1  w)rM
g ( w)  rj  rM

and

h( w)  ( w2 2j  (1  w) 2  M2  2 w(1  w) jM )1/2

w 2j  (1  w) M2  (1  2 w) jM
h( w) 
( w2 2j  (1  w) 2  M2  2 w(1  w) jM )1/2
 Deriving CAPM
Now we can compute the slope

g ( w) ( w2 2j  (1  w) 2  M2  2 w(1  w) jM )1/2

f ( P )    rj  rM 
h( w) w 2j  (1  w) M2  (1  2 w) jM

And evaluate it at w=0

g (0) (rj  rM ) M
f ( P )  
h(0)  jM   M2
 Deriving CAPM
Now recall that the slope of CML is
rM  rRF
M
And the slope of the new frontier, which is tangent to CML at M
is
(rj  rM ) M
 jM   M2
By tangency the two slopes must be equal, i.e. we must have

rM  rRF (rj  rM ) M

M  jM   M2
 Deriving CAPM
By the equality of the slopes we must have
rM  rRF (rj  rM ) M

M  jM   M2
(rM  rRF )( jM   M2 )
rj  rM 
 M2
 jM
rj  rM  (rM  rRF ) 2  (rM  rRF )
M

 jM
rj  rRF  2 (rM  rRF )
M
 Deriving CAPM
By the equality of the slopes we must have
 jM
rj  rRF  2 (rM  rRF )
M
 jM
Now let  j  2
M

The fundamental equation of CAPM then can be written as

rj  rRF   j (rM  rRF )

 Interpreting CAPM
First, lets consider what this equation implies
rj  rRF   j (rM  rRF )
There exist a linear relationship between the returns on individual assets and
their betas (as defined on the previous slide).
It is called the security market line
 Interpreting CAPM
To interpret this equation lets go back to the original formula
 jM
rj  rRF  2 (rM  rRF )
M
And define
 jM
 jM 
 j M

Then the equation can be written as

 rM  rRF 
rj  rRF     jM  j
 M 
 Interpreting CAPM
The equation now becomes

 rM  rRF 
rj  rRF     jM  j
 M 

Recall that the expression in parentheses is the market Sharpe

ratio, or the equilibrium price of risk (the slope of CML)

Since correlation varies between -1 and 1 we have

 jM  j   j

This term represents the part of the risk of j which is correlated

with the market return
 Interpreting CAPM
The fundamental equation of CAPM
 rM  rRF 
rj  rRF     jM  j
 M 

The idiosyncratic risk of asset j (part of total risk which is

uncorrelated with the market return), can be diversified away
and therefore does not affect the return on asset j

This is simply a consequence of portfolio diversification that we

studied before
 Interpreting CAPM
According to CAPM the return on asset j (and hence the price of
asset j) depends on the correlation with the market return (which
cannot be diversified away by holding the market portfolio)

• Assets with returns that a positively correlated with the market

must have expected returns above the risk free rate

• Assets which are uncorrelated with the market return have

expected return equal to the risk free rate

• Assets with returns which are negatively correlated with the

market return have expected return below the risk free rate
 Interpreting CAPM
Another way to see this is to go back to the beta formulation

rj  rRF   j (rM  rRF )

And consider a regression of a random return on an asset on a

constant and the market return
rj     j rM   j

This regression decomposes the total variance of return on asset

j into a systematic component related to the market return and a
random idiosyncratic component
 Interpreting CAPM
consider a regression of a random return on an asset on a
constant and the market return
rj     j rM   j

Recall the formula for the slope coefficient in a linear regression

 jM
cov(rj , rM )
j   2
var(rM ) M

This is of cause the expression for the beta we have seen before.
This confirms the main implication of CAPM: equilibrium prices
of assets reflect the correlation of their random returns with the
rate of return on the market portfolio