FINM7007 Applied Corporate

Finance
Lecture 4
Capital Asset Pricing Model
(CAPM)
BD Chapter 11.4-11.8, 12.1-12.3
1
11.4 Risk Versus Return:
Choosing an Efficient Portfolio
Efficient Portfolios with Two Stocks
Identifying Inefficient Portfolios
In an inefficient portfolio, it is possible to find another
portfolio that is better in terms of both expected return
and volatility.
Identifying Efficient Portfolios
Recall from Chapter 10, in an efficient portfolio there is
no way to reduce the volatility of the portfolio without
lowering its expected return.
2
Risk Versus Return: Choosing an Efficient Portfolio
(cont'd)
Efficient Portfolios with Two Stocks
Consider a portfolio of Intel and Coca-Cola
Table 11.4 Expected Returns and Volatility for Different
Portfolios of Two Stocks
3
Figure 11.3 Volatility Versus Expected Return for Portfolios
of Intel and Coca-Cola Stock
4
Risk Versus Return: Choosing an Efficient Portfolio
(cont'd)
Efficient Portfolios with Two Stocks
Consider investing 100% in Coca-Cola stock. As
shown in on the previous slide, other portfolios
such as the portfolio with 20% in Intel stock and
80% in Coca-Cola stockmake the investor better
off in two ways: It has a higher expected return,
and it has lower volatility. As a result, investing
solely in Coca-Cola stock is inefficient.
5
The Effect of Correlation
Correlation has no effect on the expected return of a
portfolio. However, the volatility of the portfolio will differ
depending on the correlation.
The lower the correlation, the lower the volatility we can
obtain. As the correlation decreases, the volatility of the
portfolio falls.
The curve showing the portfolios will bend to
the left to a greater degree as shown on the
next slide.
6
Figure 11.4 Effect on Volatility and Expected Return of Changing
the Correlation between Intel and Coca-Cola Stock
7
Short Sales
Long Position
A positive investment in a security
Short Position
A negative investment in a security
In a short sale, you sell a stock that you do not
own and then buy that stock back in the future.
Short selling is an advantageous strategy if you
expect a stock price to decline in the future.
8
Figure 11.5 Portfolios of Intel
and Coca-Cola Allowing for Short Sales
9
Efficient Portfolios with Many Stocks
Consider adding Bore Industries to the two
stock portfolio:
Although Bore has a lower return and the same
volatility as Coca-Cola, it still may be beneficial to add
Bore to the portfolio for the diversification benefits.
10
Figure 11.6 Expected Return and Volatility for Selected Portfolios
of Intel, Coca-Cola, and Bore Industries Stocks
11
Figure 11.7 The Volatility and Expected
Return for All Portfolios of Intel, Coca-Cola, and Bore Stock
12
Risk Versus Return: Many Stocks
The efficient portfolios, those offering the
highest possible expected return for a given
level of volatility, are those on the northwest
edge of the shaded region, which is called the
efficient frontier for these three stocks.
In this case none of the stocks, on its own, is on
the efficient frontier, so it would not be efficient
to put all our money in a single stock.
13
Figure 11.8 Efficient Frontier with Ten
Stocks Versus Three Stocks
14
Risk-Free Saving and Borrowing
Risk can also be reduced by investing a portion
of a portfolio in a risk-free investment, like T-Bills. However,
doing so will likely reduce the expected return.
On the other hand, an aggressive investor who
is seeking high expected returns might decide
to borrow money to invest even more in the
stock market.
15
Figure 11.9 The RiskReturn Combinations from Combining a
Risk-Free Investment and a Risky Portfolio
16
Borrowing and Buying Stocks on
Margin
Buying Stocks on Margin
Borrowing money to invest in a stock.
A portfolio that consists of a short position in the
risk-free investment is known as a levered
portfolio. Margin investing is a risky investment
strategy.
17
Identifying the Tangent Portfolio
To earn the highest possible expected return
for any level of volatility we must find the
portfolio that generates the steepest possible
line when combined with the risk-free
investment.
18
Identifying the Tangent Portfolio
(cont'd)
Sharpe Ratio
Measures the ratio of reward-to-volatility provided by
a portfolio
The portfolio with the highest Sharpe ratio is the
portfolio where the line with the risk-free investment is
tangent to the efficient frontier of risky investments. The
portfolio that generates this tangent line is known as the
tangent portfolio.
[ ]
Portfolio Excess Return
Sharpe Ratio
Portfolio Volatility ( )

= =
P f
P
E R r
SD R
19
Figure 11.10 The Tangent or Efficient
Portfolio
20
Identifying the Tangent Portfolio
(cont'd)
Combinations of the risk-free asset and the
tangent portfolio provide the best risk and
return tradeoff available to an investor.
This means that the tangent portfolio is efficient
and that all efficient portfolios are combinations
of the risk-free investment and the tangent
portfolio. Every investor should invest in the
tangent portfolio independent of his or her taste
for risk.
21
Identifying the Tangent Portfolio
(cont'd)
An investors preferences will determine only how much to
invest in the tangent portfolio versus the risk-free investment.
Conservative investors will invest a small amount
in the tangent portfolio.
Aggressive investors will invest more in the
tangent portfolio.
Both types of investors will choose to hold the same portfolio of risky
assets, the tangent portfolio, which
is the efficient portfolio.
22
Expected Returns
and the Efficient Portfolio
Expected Return of a Security
A portfolio is efficient if and only if the expected
return of every available security equals its
required return.
[ ] ( [ ] ) = +
eff
i i f i eff f
E R r r E R r |
23
11.7 The Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) allows
us to identify the efficient portfolio of risky
assets without having any knowledge of the
expected return of each security.
Instead, the CAPM uses the optimal choices
investors make to identify the efficient
portfolio as the market portfolio, the portfolio
of all stocks and securities in the market.
24
The CAPM Assumptions
Three Main Assumptions
Assumption 1
Investors can buy and sell all securities at competitive
market prices (without incurring taxes or transactions
costs) and can borrow and lend at the risk-free interest
rate.
25
The CAPM Assumptions (cont'd)
Three Main Assumptions
Assumption 2
Investors hold only efficient portfolios of traded
securitiesportfolios that yield the maximum
expected return for a given level of volatility.
26
The CAPM Assumptions (cont'd)
Three Main Assumptions
Assumption 3
Investors have homogeneous expectations regarding
the volatilities, correlations, and expected returns of
securities.
Homogeneous Expectations
All investors have the same estimates concerning future
investments and returns.
27
Supply, Demand, and the Efficiency of
the Market Portfolio
Given homogeneous expectations, all investors will demand
the same efficient portfolio of
risky securities.
The combined portfolio of risky securities of all investors must
equal the efficient portfolio.
Thus, if all investors demand the efficient portfolio, and the
supply of securities is the market portfolio, the demand for
market portfolio must equal the supply of the market
portfolio.
28
Example
29
Example (cont'd)
30
Optimal Investing: The Capital Market
Line
When the CAPM assumptions hold, an
optimal portfolio is a combination of the risk-
free investment and the market portfolio.
When the tangent line goes through the market
portfolio, it is called the capital market line (CML).
31
Optimal Investing:
The Capital Market Line (cont'd)
The expected return and volatility of a capital
market line portfolio are:
[ ] (1 ) [ ] ( [ ] ) = + = +
xCML f Mkt f Mkt f
E R x r xE R r x E R r
( ) ( ) =
xCML Mkt
SD R xSD R
32
Figure 11.11 The Capital Market Line
33
Determining the Risk Premium
Market Risk and Beta
Given an efficient market portfolio, the expected
return of an investment is:
The beta is defined as:
Risk premium for security
[ ] ( [ ] ) = = +
Mkt
i i f i Mkt f
i
E R r r E R r |
Volatility of that is common with the market
i
( ) ( , ) ( , )

( ) ( )

= =
i
Mkt
i i Mkt i Mkt
i
Mkt Mkt
SD R Corr R R Cov R R
SD R Var R
| |
34
Example
Problem
Assume the risk-free return is 5% and the market
portfolio has an expected return of 12% and a
standard deviation of 44%.
ATP Oil and Gas has a standard deviation of 68%
and a correlation with the market of 0.91.
What is ATPs beta with the market?
Under the CAPM assumptions, what is its
expected return?
35
Example (contd)
Solution

i
( ) ( , ) (.68)(.91)
1.41
( ) .44

= = =
i i Mkt
Mkt
SD R Corr R R
SD R
|
[ ] ( [ ] ) 5% 1.41(12% 5%) 14.87% = + = + =
Mkt
i f i Mkt f
E R r E R r |
36
The Security Market Line
There is a linear relationship between a stocks
beta and its expected return (See figure on
next slide). The security market line (SML) is
graphed as the line through the risk-free
investment and the market.
According to the CAPM, if the expected return and
beta for individual securities are plotted, they
should all fall along the SML.
37
Figure 11.12 The Capital Market Line
and the Security Market Line
38
Figure 11.12 The Capital Market Line and the Security
Market Line, panel (a)
(a) The CML depicts
portfolios combining
the risk-free
investment and the
efficient portfolio, and
shows the highest
expected return that
we can attain for
each level of volatility.
According to the
CAPM, the market
portfolio is on the
CML and all other
stocks and portfolios
contain diversifiable
risk and lie to the
right of the CML, as
illustrated for Exxon
Mobil (XOM).
39
Figure 11.12 The Capital Market Line and the Security
Market Line, panel (b)
(b) The SML shows the
expected return for each
security as a function of
its beta with the market.
According to the CAPM,
the market portfolio is
efficient, so all stocks
and portfolios should lie
on the SML.
40
The Security Market Line (cont'd)
Beta of a Portfolio
The beta of a portfolio is the weighted average
beta of the securities in the portfolio.
( )
,
( , ) ( , )

( ) ( ) ( )
= = = =

i i Mkt
i
P Mkt i Mkt
P i i i
i i
Mkt Mkt Mkt
Cov x R R
Cov R R Cov R R
x x
Var R Var R Var R
| |
41
Example
42
Example (contd)
43
Alpha (cont'd)
When the market portfolio is efficient, all
stocks are on the security market line and
have an alpha of zero.
Investors can improve the performance of
their portfolios by buying stocks with positive
alphas and by selling stocks with negative
alphas.
Figure An Inefficient Market Portfolio
Figure Deviations from the Security
Market Line
Summary of the Capital Asset
Pricing Model
The market portfolio is the efficient portfolio.
The risk premium for any security is
proportional to its beta with the market.
Determining Beta
Estimating Beta from Historical Returns
Recall, beta is the expected percent change in
the excess return of the security for a 1%
change in the excess return of the market
portfolio.
Consider Cisco Systems stock and how it changes
with the market portfolio.
Monthly Returns for Cisco Stock and
for the S&P 500, 19962005
Scatterplot of Monthly
Excess Returns for Cisco Versus
the S&P 500, 19962005
Determining Beta (cont'd)
Estimating Beta from Historical Returns
As the scatterplot on the previous slide shows,
Cisco tends to be up when the market is up, and
vice versa.
We can see that a 10% change in the markets
return corresponds to about a 20% change in
Ciscos return.
Thus, Ciscos return moves about two for one with the
overall market, so Ciscos beta is about 2.
Determining Beta (cont'd)
Estimating Beta from Historical Returns
Beta corresponds to the slope of the best-fitting
line in the plot of the securitys excess returns
versus the market excess return.
Using Linear Regression
Linear Regression
The statistical technique that identifies the best-
fitting line through a set of points.

i
is the intercept term of the regression.

i
(R
Mkt
r
f
) represents the sensitivity of the stock to
market risk.

i
is the error term and represents the deviation from
the best-fitting line and is zero on average.
( ) ( ) = + +
i f i i Mkt f i
R r R r o | c
Using Linear Regression (cont'd)
Linear Regression
Since E[
i
] = 0:

i
represents a risk-adjusted performance measure for
the historical returns.
If
i
is positive, the stock has performed better than predicted
by the CAPM.
If
i
is negative, the stocks historical return is below the SML.
Distance above / below the SML
Expected return for from the SML
[ ] ( [ ] ) = + +
i f i Mkt f i
i
E R r E R r | o
Using Linear Regression (cont'd)
Linear Regression
Given data for r
f
, R
i
, and R
Mkt
, statistical packages
for linear regression can estimate
i
.
A regression for Cisco using the monthly returns for
19962004 indicates the estimated beta is 1.94.
The estimate of Ciscos alpha from the regression is
1.2%.
Investor Information
and Rational Expectations
In the CAPM framework, investors should
hold the market portfolio combined with
risk-free investments
This investment advice does not depend on the
quality of an investors information.
Investor Information
and Rational Expectations (cont'd)
Rational Expectations
Investors may have different information
regarding expected returns, correlations, and
volatilities, but they correctly interpret that
information and the information contained in
market prices and adjust their estimates of
expected returns in a rational way.
Example
Example (cont'd)
Investor Information
and Rational Expectations (cont'd)
Regardless of how much information an
investor has access to, he can guarantee
himself an alpha of zero by holding the market
portfolio.
Investor Information
and Rational Expectations (cont'd)
Because the average portfolio of all investors
is the market portfolio, the average alpha of
all investors is zero.
If no investor earns a negative alpha, then no
investor can earn a positive alpha, and the
market portfolio must be efficient.
Investor Information
and Rational Expectations (cont'd)
The market portfolio can be inefficient only if
a significant number of investors either:
Misinterpret information and believe they are
earning
a positive alpha when they are actually earning a
negative alpha, or
Care about aspects of their portfolios other than
expected return and volatility, and so are willing to
hold inefficient portfolios of securities.
The CAPM in Practice
Forecasting Beta
Time Horizon
For stocks, common practice is to use at least two years
of weekly return data or five years of monthly return
data.
The Market Proxy
In practice the S&P 500 is used as the market proxy.
Other proxies include the NYSE Composite Index
and the Wilshire 5000.
The CAPM in Practice (cont'd)
Forecasting Beta
Beta Extrapolation
Many practitioners prefer to use average industry betas
rather than individual stock betas.
In addition, evidence suggests that betas tend to
regress toward the average beta of 1.0 over time.
The CAPM in Practice (cont'd)
Forecasting Beta
Outliers
The beta estimates obtained from linear regression can
be very sensitive to outliers.
Beta Estimation with and without Outliers for
Genentech Using Monthly Returns for 20022004
The CAPM in Practice (cont'd)
Forecasting Beta
Other Considerations
Historical betas may not be a good measure if a firm
were to change industries.
Evidence Regarding the CAPM
Historically, researchers have found that
expected returns were related to betas, as
predicted by the CAPM, rather than to
other measures of risk such as the
securitys volatility.
However, they did find the empirically
estimated security market line is somewhat
flatter than that predicted by the CAPM, as
shown on the next slide.
Empirical SML Versus
SML Predicted by CAPM (Black, Jensen,
and Scholes, 1972)
Evidence Regarding the CAPM
(cont'd)
More recently, researchers have found
problems with the CAPM:
Betas are not observed.
If betas change over time, evidence against the CAPM
may be the result of mismeasuring betas.
Evidence Regarding the CAPM
(cont'd)
More recently, researchers have found
problems with the CAPM:
Expected returns are not observed.
Even if beta is a perfect measure of risk, average
returns need not match expected returns. The realized
average return need not match investors expectations.
Evidence Regarding the CAPM
(cont'd)
More recently, researchers have found
problems with the CAPM:
The market proxy is not correct.
Although the S&P 500 is a reasonable proxy for the U.S.
stock market, investors hold many other assets. For
example, the U.S. stock market represents only about
50% of world equity markets.
Any failure of the CAPM may simply be the result of our
failure to find a good measure of the market portfolio.
The Bottom Line on the CAPM
The CAPM remains the predominant model
used in practice to determine the equity cost
of capital.
Although the CAPM is not perfect, it is unlikely
that a truly perfect model will be found in the
foreseeable future.
The imperfections of the CAPM may not be critical in
the context of capital budgeting.
Errors in estimating project cash flows are likely to be far more
important than small discrepancies in the cost of capital.