Capital Market Theory and

Asset Pricing Models

Chapter 9
Charles P. Jones, Investments: Analysis and Management,
Twelfth Edition, John Wiley & Sons

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 Positive rather than normative
◦ Describes how investors could behave not how
they should be have
 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

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 Assumes all  No transaction costs,
investors: no personal income
◦ Use the same taxes, no inflation
information to generate  No single investor
an efficient frontier
can affect the price
◦ Have the same one-
period time horizon of a stock
◦ Can borrow or lend  Capital markets are
money at the risk-free in equilibrium
rate of return

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Risk-Free Assets, Borrowing, Lending

 Risk free assets

◦ No correlation with risky assets
◦ Usually proxied by a Treasury security
 Adding a risk-free asset extends and changes
the efficient frontier
 “Lending” because investor lends money to
issuer
 With borrowing, investor no longer restricted
to own wealth

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 Riskless assets can
L be combined with
any portfolio in the
B
efficient set AB
E(R) T ◦ Z implies lending
Z X  Set of portfolios on
RF line RF to T
A dominates all
portfolios below it

Risk
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 Risk-free investing and borrowing creates a
new set of expected return-risk possibilities
 Addition of risk-free asset results in
◦ A change in the efficient set from an arc to a
straight line tangent to the feasible set without the
riskless asset
◦ Chosen portfolio depends on investor’s risk-return
preferences

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  Line from RF to L is
L capital market line
(CML)
M
E(RM)  x = risk premium
=E(RM) - RF
x  y =risk =M
RF  Slope =x/y
y =[E(RM) - RF]/M
 y-intercept = RF
M
Risk

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 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):

E(RM )  RF
E(Rp )  RF  p
M

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 Most important implication of the CAPM
◦ The portfolio of all risky assets is the optimal risky
portfolio (called the market portfolio)
◦ The expected price of risk is always positive
◦ The optimal portfolio is at the highest point of
tangency between RF and the efficient frontier
◦ All investors hold the same optimal portfolio of
risky assets

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 All risky assets must be in portfolio, so it is
completely diversified
◦ Includes only systematic risk
 Unobservable but approximated with
portfolio of all common stocks
◦ In turn approximated with S&P 500
 All securities included in proportion to their
market value

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 Investors use their preferences (reflected in an
indifference curve) to determine optimal
portfolio
 Separation Theorem
◦ The investment decision about which risky portfolio
to hold is separate from the financing decision
 Investment decision does not involve investor
 Financing decision depends on investor’s preferences

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 CML Equation only applies to markets in
equilibrium and efficient portfolios
 The Security Market Line depicts tradeoff
between risk and expected return for
individual securities
 Under CAPM, all investors hold the market
portfolio
◦ Relevant risk of any security is therefore its
covariance with the market portfolio

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Beta
 Standardized measure of systematic risk
 Relative measure of risk: risk of an individual
stock relative to the market portfolio of all
stocks
 Relates covariance of an asset with the
market portfolio to the variance of the market
portfolio Covi, M

2M

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Beta

SML  Beta = 1.0 implies as

E(R) risky as market
 Securities A and B are
A
kM B
more risky than the
market
C
kRF ◦ Beta >1.0
 Security C is less
risky than the market
0 0.5 1.0 1.5 2.0 ◦ Beta <1.0
BetaM

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 Required rate of return on an asset (ki) is
composed of
◦ risk-free rate (RF)
◦ risk premium (i [ E(RM) - RF ])
 Market risk premium adjusted for specific security
ki = RF +i [ E(RM) - RF ]
◦ The greater the systematic risk, the greater the
required return

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 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

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 Market model
◦ Relates the return on each stock to the return on
the market, assuming a linear relationship
◦ Produces an estimate of return for any stock
Ri =i +i RM +ei
 Characteristic line
◦ Line fit to total returns for a security relative to total
returns for the market index

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 Betas change with a company’s situation
 Estimating a future beta
◦ May differ from the historical beta
 RM represents the total of all marketable
assets in the economy
◦ Approximated with a stock market index
◦ Approximates return on all common stocks

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 No one correct number of observations and
time periods for calculating beta
◦ Therefore, estimates of beta vary
 The regression calculations of the true  and
 from the characteristic line are subject to
estimation error
 Portfolio betas more reliable than individual
security betas

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Tests of CAPM
 Assumptions are mostly unrealistic
 Empirical evidence has not led to consensus
 However, some points are widely agreed upon
◦ SML appears to be linear
◦ Intercept is generally higher than RF
◦ Slope of the CAPM is generally less than theory
predicts
◦ It’s likely that only systematic risk is rewarded

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 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

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 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 non-zero prices
◦ Risk factors must be unpredictable to the market

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 Most important are the deviations of the
factors from their expected values
◦ Expected return is directly related to sensitivity
◦ CAPM assumes risk is only sensitivity to market
 The expected return-risk relationship for the
APT can be described as:
E(Ri) =RF +bi1 (risk premium for factor 1) +bi2
(risk premium for factor 2) +… +bin (risk
premium for factor n)

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 Factors are not well specified ex ante
◦ To implement the APT model, need the factors that
account for the differences among security returns
 CAPM identifies market portfolio as single factor
 Studies suggest certain factors are reflected
in market
◦ Focus on cash flows and discount rate
 Both CAPM and APT rely on unobservable
expectations

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