07 33172

Corporate Finance
Topic 6 – Capital-Asset-Pricing-
Model

Objective
Explain and use the
capital-asset-pricing-model

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 Capital Asset Pricing Model
(CAPM): Introduction (1)
• CAPM is a theory about equilibrium prices
in the markets for risky assets
• It is important because it provides
– a justification for the widespread practice of
passive investing called indexing
– a way to estimate expected rates of return
for use in evaluating stocks and investment
projects
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 CAPM: Introduction (2)
• Developed in the 1960’s by Sharpe
• It answers the question
– What would the equilibrium risk premium be
if every investor
• had the same set of forecasts for expected
returns, and risk and correlations of returns
• chose their portfolio according the principles
of efficient diversification
• and hence held risky assets in the same
relative proportions 3
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 Market Portfolio
• Since all investors have the same relative
holdings of risky securities, the only way the
asset market can clear is if these optimal
relative holdings equate to the proportions in
which the risky assets are valued in the market
place (i.e. if they equate to the Market
Portfolio)
• Thus, the equilibrium proportion of each asset
in the market portfolio must be
Market value of individual asset i
wi 
Market Value of all assets
• Depending on their risk aversions, different
investors hold portfolios with different mixes of
a riskless asset and the market portfolio 4
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 Market Portfolio (World with
Three Risky Assets)
No. of Share Mkt % of Mkt
Shares Price Value Portfolio
Stock 1 100 10 1,000 10
Stock 2 50 100 5,000 50
Stock 3 200 20 4,000 40
Total (Mkt Portfolio) 350 10,000 100

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 Tradeoff Between Expected
Return and Risk
• Assume a world with a single risky asset
and a single riskless asset
• The risky asset is, in the real world, a
portfolio of risky assets (the market
portfolio)
• The risk-free asset is a default-free bond
with the same maturity as the investor’s
decision (or possibly trading) horizon
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07 33172 – Topic 6
 Combining the Riskless Asset
and a Single Risky Asset (1)
• Assume that you invest proportion w1 of
your wealth in security 1 and proportion
w2 of your wealth in security 2
• You must invest in either security 1 or
security 2, so w1+ w2 = 1
• Let security 2 be the riskless asset, and
security 1 be the risky asset (market
portfolio)
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07 33172 – Topic 6
 Combining the Riskless Asset
and a Single Risky Asset (2)
– The expected return of the portfolio is the
weighted average of the component returns:

p = W1*1 + W2*2
p = W1*1 + (1 – W1)*2
– The risk of the portfolio is:

p  (w1212  w2222 2w1w2121,2)1/ 2

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07 33172 – Topic 6
 Combining the Riskless Asset
and a Single Risky Asset (3)

– We know something special about the portfolio;

namely that security 2 is riskless: so 2 = 0, and
p becomes:

 p  (w1212  w22 02  2w1w2101,2 )1/ 2

 w11

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07 33172 – Topic 6
 Combining the Riskless Asset
and a Single Risky Asset (4)
– In summary

W1 p/1 and:

p = W1*1 + (1 – W1)*rf , so:

=> p = rf + [(1 – rf)/ 1]*p
<=> p – rf = [(1 – rf)/ 1]*p
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07 33172 – Topic 6
 Optimal Portfolio Selection with
Lending and Borrowing green line
represents different
Capital weights of
Expected return

investment in risky
Market and riskless asset
Line
Borrow Efficient
frontier
efficient frontier
M has to be
upward sloping
Lend Optimal portfolio because for
portfolio
= market portfolio (M) efficiency taking
Risk-free a higher risk has
rate to give higher
reward

Portfolio risk ( 11

07 33172 – Topic 6

before m is where you invest some in riskless and some in risky

m= where you invest 100% of wealth in market portfolio
after m you borrow to investt more in market so weight in riskless = minus
( only looking at straight line)
 Optimal Portfolio Selection with
Lending and Borrowing:
Observations
– The red line in the previous diagram has
been labeled the “capital market line (CML)”.
If
• the risky security is the market portfolio of
risky securities, and
• investors have similar expectations and time
horizons
=> all investors will invest (long or short) in
the market portfolio and risk-free security
– The CML joins the capital markets for risky
and riskless securities
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 Reward Only for Market Risk

• The risk premium on any individual security is

proportional only to its contribution to the risk
of the market portfolio, and does not depend
on its stand-alone risk
• Investors are rewarded only for bearing market
risk, i.e. non-diversifiable risk
 M  rf
• Slope of CML:
M
gives the market price of non-diversifiable risk
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 CAPM Derivation (1)
• From regression analysis (covered at the
end of this topic), we know that the part
of the variance of security i that is
explained by the market portfolio M is
 i2,nondiv   i2 i2,M
where
 i2,nondiv is the market  related risk of security i
i,M is the correlation between the market and security i

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 CAPM Derivation (2)
• In terms of standard deviation:
 i ,nondiv   i i , M
• and multiplying by the market price of non-
diversifiable risk:  M  rf
M
• yields the excess return of security i over the
risk-free rate:
 M  rf 
CAPM ri  rf   i i,M  (M  rf ) i ,2M  M  rf i
M M
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07 33172 – Topic 6
 CAPM Equation
Market risk premium

E(Ri) = Rf + [E(RM) – Rf] i

Where E(Ri) = expected return on security i

Rf = return on risk-free security
E(RM) = expected return on market
portfolio
i = beta of security i

i = R , R / 2RM
i M
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 Security Market Line (SML)

• The plot of individual security returns (or

sometimes their risk premiums) against their
betas
– Note that the slope of the SML is determined by the
market risk premium
– By CAPM theory, all securities must fall precisely on
the SML (hence its name)

• All securities plot onto the SML, if they are

correctly priced according to the CAPM

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07 33172 – Topic 6
 Security Market Line Market
Portfolio
20%

15%

10%
Expected Risk Premium

5%

0%
-2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0
-5%

-10%

-15%

-20%
Beta (Risk)

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 Capital Market Line (CML) and
Security Market Line (SML)
CML
 r  rf 

p
M  rf 
p
M

  r  rf 
 M  rf 
p
p
M

SML
r  rf  M  rf i
i

 ri  rf   M  rf i 19
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 Beta and Systematic Risk
• The beta coefficient, , tells us the response of
the stock’s return to systematic risk.
• In the CAPM,  measured the responsiveness of
a security’s return to a specific systematic risk
factor – the return on the market portfolio.

Cov ( Ri , RM )
i 
 2 ( RM )

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 Example:  > 1

• A security with a  > 1 on average rises

and falls more than the market
– With a  = 1.3, a 10% (say) unexpected rise
(fall) in the market return premium will, on
average, result in a 13% rise (fall) in the
security’s return premium

• Such a security is said to be aggressive

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07 33172 – Topic 6
 Example:  < 1

• A security with a  < 1 on average rises

and falls less than the market
– With a  = 0.7, a 10% (say) unexpected rise
(fall) in the market return premium will, on
average, result in a 7% rise (fall) in the
security’s return premium

• Such a security is said to be defensive

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 Determinants of Beta
• Beta is determined by
– Business risk
• Cyclicality of revenues
• Operating leverage (industry)
– Financial Risk
• Financial leverage

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 Beta of a Portfolio

• When determining the risk of a portfolio

– using standard deviation results in a formula
that is quite complex
1

  
 w1r1  w2 r2 ... wn rn    wi ri 2  2 wi w j ri  r j  i , j 
2


 i 1,n i j 
– using beta, the formula is linear
 w r  w r ... w r  w1  r  w2  r  ...  wn  r   wi  r
11 2 2 n n 1 2 n i
i
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 Beta of a Portfolio: Example

• Compute the beta of a portfolio

composed of 40% stock A with a beta of
0.8 and 60% stock B with a beta of 1.3:
 portfolio  wA  A  wB  B
 portfolio  0.40 * 0.8  0.60 *1.3
 portfolio  1.1
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07 33172 – Topic 6
 Calculation of Required
Return: Example

• Assume the risk-free rate is 5% and the

return on the market is 15%
• To find the required return on a project
with a beta of 1.04, apply the CAPM
 r  r f    m  r f 
 0.05  1.040.15  0.05 
 15.4% 26
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 Calculation of Cost of Equity
Capital: Example

• Assume the risk-free rate is 6% and the

risk premium on the market is 8%
• To find the cost of equity capital on ABC
stock with a beta of 1.1, apply the CAPM
 r  r f    m  r f 
 0 . 06  1 . 10 . 08 
 14 . 8 %
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07 33172 – Topic 6