09

INVESTMENTS:
Analysis and Management

Third Canadian Edition

W. Sean Cleary
Charles P. Jones

Prepared by
Khalil Torabzadeh
University of Lethbridge
Chapter 9
Capital Market Theory
Cleary Jones/Investments: Analysis and Management, 3
rd
Canadian Edition, Chapter 9
Explain capital market theory and the Capital Asset
Pricing Model (CAPM).
Discuss the importance and composition of the
market portfolio.
Describe two important relationships in CAPM as
represented by the capital market line and the
security market line.
Describe how betas are estimated and how beta is
used.
Discuss the Arbitrage Pricing Theory as an
alternative to the Capital Asset Pricing Model.
Learning Objectives
rd
Focus on the equilibrium relationship between
the risk and expected return on risky assets
Builds on Markowitz portfolio theory
Each investor is assumed to diversify his or her
portfolio according to the Markowitz model
Capital Asset Pricing Model
(CAPM)
rd
All investors:
Use the same
information to
generate an efficient
frontier
Have the same one-
period time horizon
Can borrow or lend
money at the risk-free
rate of return
No transaction costs,
no personal income
taxes, no inflation
No single investor can
affect the price of a
stock
Capital markets are in
equilibrium
Assumptions of the CAPM
rd
Most important implication of the CAPM
All investors hold the same optimal portfolio of
risky assets
The optimal portfolio is at the highest point of
tangency between RF and the efficient frontier
The portfolio of all risky assets is the optimal
risky portfolio
Called the market portfolio
The Market Portfolio
rd
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 S&P/TSX
Composite Index
In theory, should contain all risky assets
worldwide
Composition of the Market Portfolio
rd
Line from RF to L is capital market line (CML)
Figure 9-2 The Capital Market Line
and the Components of Its Slope
rd
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):
p
M
M
p
RF ) R ( E
RF ) R ( E o
o

+ =
The Capital Market Line
rd
The Capital Market Line
RF is the price of forgone consumption
E(R
M
) RF/
M
is the market price of risk

P
is the amount of risk taken on a particular
portfolio

rd
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, inefficient portfolios, or efficient
portfolios
Under CAPM, all investors hold the market
portfolio. The important issue is: How does an
individual security contribute to the risk of the
market portfolio?
The Security Market Line
rd
Equation for expected return for an individual
stock similar to CML Equation
| | RF ) R ( E RF
RF ) R ( E
RF ) R ( E
M i
M
M , i
M
M
i
+ =
+ =
|
o
o
o
rd
Beta = 1.0
implies as risky
as market
Securities Y and
Z are more risky
than the market
Beta > 1.0
Security X is less
risky than the
market
Beta < 1.0
Figure 9-3 The Security Market
Line
rd
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
rd
E
r

Underpriced SML: E
r
= r
f
+ | (E
rm
r
f
)

Overpriced

rf

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
SML and Asset Values

rd
Required rate of return on an asset (k
i
) is
composed of
risk-free rate (RF)
risk premium (|
i
[ E(R
M
) - RF ])
Market risk premium adjusted for specific
security
k
i
= RF +|
i
[ E(R
M
) - RF ]
The greater the systematic risk, the greater
the required return
CAPMs Expected Return-Beta
Relationship
rd
Treasury Bill rate used to estimate RF
Expected market return unobservable
Estimated using past market returns and taking
an expected value
Estimating individual security betas difficult
Only company-specific factor in CAPM
Requires asset-specific forecast
Estimating the SML
rd
Market model
Relates the return on each stock to the return
on the market, assuming a linear relationship
R
it
=o
i
+|
i
R
Mt
+ e
it

Characteristic line
Line fit to total returns for a security relative to
total returns for the market index
Estimating Beta
rd
Betas change with a companys situation
Not stationary over time
Estimating a future beta
May differ from the historical beta
R
Mt
represents the total of all marketable assets
in the economy
Approximated with a stock market index
Approximates return on all common stocks
How Accurate Are Beta Estimates?
rd
No one correct number of observations and
time periods for calculating beta
The regression calculations of the true o and
| from the characteristic line are subject to
estimation error
Portfolio betas more reliable than individual
security betas
How Accurate Are Beta Estimates?
rd
Empirical SML is flatter than predicted SML
Fama and French (1992)
Market
Size
Book-to-market ratio
Rolls Critique
True market portfolio is unobservable
Tests of CAPM are merely tests of the mean-
variance efficiency of the chosen market proxy
Tests of CAPM
rd
Based on the Law of One Price
Two otherwise identical assets cannot sell at
different prices
Equilibrium prices adjust to eliminate all
arbitrage opportunities
Unlike CAPM, APT does not assume
single-period investment horizon, absence of
personal taxes, riskless borrowing or lending,
mean-variance decisions
Arbitrage Pricing Theory
rd
APT assumes returns generated by a factor
model
Factor Characteristics
Each risk must have a pervasive influence on
stock returns
Risk factors must influence expected return and
have nonzero prices
Risk factors must be unpredictable to the market
Factor Model
rd
Most important are the deviations of the
factors from their expected values
The expected return-risk relationship for the
APT can be described as:
E(R
it
) =a
0
+b
i1
(risk premium for factor 1) +b
i2

(risk premium for factor 2) + +b
in
(risk
premium for factor n)
APT Model
rd
Reduces to CAPM if there is only one factor
and that factor is market risk
Roll and Ross (1980) Factors:
Changes in expected inflation
Unanticipated changes in inflation
Unanticipated changes in industrial production
Unanticipated changes in the default risk
premium
Unanticipated changes in the term structure of
interest rates
APT Model
rd
Factors are not well specified ex ante
To implement the APT model, the factors that
account for the differences among security
returns are required
CAPM identifies market portfolio as single
factor
Neither CAPM or APT has been proven
superior
Both rely on unobservable expectations
Limitations of APT
rd
Copyright 2009 John Wiley & Sons Canada, Ltd. All rights
reserved. Reproduction or translation of this work beyond that
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