Capital Asset Pricing

Model
Hardik Gandhi

Assumptions
All investors are Markowitz efficient investors
who want to target points on the efficient
frontier
Investors can borrow or lend any amount of
money at the risk-free rate of return (RFR)
All investors have homogeneous expectations;
that is, they estimate identical probability
distributions for future rates of return
All investors have the same one-period time
horizon such as one-month, six months, or one
year

Contd.
All investments are infinitely divisible, which
means that it is possible to buy or sell
fractional shares of any asset or portfolio
There are no taxes or transaction costs
involved in buying or selling assets
There is no inflation or any change in interest
rates, or inflation is fully anticipated
Capital markets are in equilibrium, implying
that all investments are properly priced in line
with their risk levels

Background to Capital
Market Theory
The CAPM is an equilibrium model that
encompasses two important relationships:

The capital market line (CML), specifies the

equilibrium relationship between expected
return and total risk for efficient portfolios

The security market line (SML), specifies the

equilibrium relationship between expected
return and systematic risk

Capital Market Line

Development of the Theory
The major factor that allowed portfolio theory
to develop into capital market theory is the
concept of a risk-free asset
An asset with zero standard deviation
Zero correlation with all other risky assets
Provides the risk-free rate of return (RFR)
Will lie on the vertical axis of a portfolio
graph

Developing the Capital

Market Line
The Capital Market Line
With these results, we can develop the riskreturn
relationship between E(Rport) and port

E(RM ) RFR
E(Rport ) RFR port [
]
M
This relationship holds for every combination of
the risk-free asset with any collection of risky
assets
However, when the risky portfolio, M, is the
market portfolio containing all risky assets held
anywhere in the marketplace, this linear
relationship is called the Capital Market Line

Risk-Return Possibilities

Borrowing and Lending at Risk Free

Rate

Risk, Diversification & the

Market Portfolio
The CML & the Separation Theorem
Risk averse investors will lend at the risk-free rate
while investors preferring more risk might borrow
funds at the RFR and invest in the market portfolio
The investment decision of choosing the point on
CML is separate from the financing decision of
reaching there through either lending or borrowing

Using the CML to Invest: An

Example
Suppose you have a riskless security at 4% and a market portfolio with
a return of 9% and a standard deviation of 10%. How should you go
about investing your money so that your investment will have a risk
level of 15%?

Portfolio Return
E(Rport)=RFR+port[(E(RM)-RFR)/M)
E(Rport)=4%+15%[(9%-4%)/10%]
E(Rport)=11.5%
Continued

Using the CML to Invest: An

Example
How much to invest in the riskless security?
11.5%= wRF (4%) + (1-wRF )(9%)
wRF= -0.5

The investment strategy is to borrow 50%

and invest 150% of equity in the market
portfolio

All portfolios on the CML are perfectly positively

correlated with each other and with the
completely diversified market Portfolio M
A completely diversified portfolio would have a
correlation with the market portfolio of +1.00
Complete
risk
diversification
means
the
elimination of all the unsystematic or unique risk
and the systematic risk correlates perfectly with
the market portfolio

Security Market Line

CML Equation only applies to markets in
equilibrium and efficient portfolios (i.e., cannot be
used to assess the expected return on individual
securities or inefficient portfolios)
The Security Market Line depicts the tradeoff
between risk and expected return for individual
securities
Under CAPM, all investors hold the risky portion of
their portfolio in the market portfolio
How does an individual security contribute to
the risk of the market portfolio?

Security Market Line

The SML represents the trade-off between
systematic risk () and the expected return for
all assets, whether individual securities,
inefficient portfolios, or efficient portfolios
Beta measures systematic risk

Measures relative risk compared to the market

portfolio of all stocks
Volatility of security i is different (higher or lower)
than that of the market if _i > 1 or _i < 1 and is
equal to that of the market if _i = 1
_i = 1 means that for every 1% change in the
markets return, on average security is returns
change 1%
_M = 1 and _RF = 0

Security Market Line (CAPM)

E(Ri ) RFR i [E(RM ) RFR]

The CAPM indicates what should be the expected
or required rates of return on risky assets
This helps to value an asset by providing an
appropriate discount rate to use in dividend
valuation models

The Security Market Line

(SML)

The SML is a graphical form of the CAPM

Shows the relationship between the expected or required rate of
return and the systematic risk on a risky asset

The Capital Asset Pricing

Model
Identifying Undervalued &
Overvalued Assets
In equilibrium, all assets and all
portfolios of assets should plot on the
SML
Any security with an estimated return
that plots above the SML is underpriced
Any security with an estimated return
that plots below the SML is overpriced

SML and Asset Values

Er

Underpriced

SML: Er = rf + (Erm rf)

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