ECON2191
CORPORATE FINANCE
Lecture 6: CAPM
Dr Lilly Xinyi Huang Michaelmas
Term 2021/22
Readings
• “Principles of Corporate Finance”
• Brealey, Myers, Allen (13th ed)
• Chapter 8 (8-3)
The Efficient Set for Two Assets
% in stocks Risk Return
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4% 100%
15% 4.8% 7.6% stocks
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2% 100%
35% 0.4% 8.4% bonds
40% 0.9% 8.6%
45% 2.0% 8.8%
50.00% 3.08% 9.00%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0% We can consider other portfolio weights
80% 9.8% 10.2%
85% 10.9% 10.4% besides 50% in stocks and 50% in bonds.
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
Efficient Portfolio
• For a given return , an efficient portfolio is one that
solves:
The Efficient Set for Two Assets
% in stocks Risk Return
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8% 100%
25% 2.6% 8.0% stocks
30% 1.4% 8.2%
35% 0.4% 8.4%
100%
40% 0.9% 8.6%
45% 2.0% 8.8%
bonds
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75%
80%
8.7%
9.8%
10.0%
10.2%
Note that some portfolios are “better” than
85% 10.9% 10.4% others. They have higher returns for the
90% 12.1% 10.6%
95% 13.2% 10.8%
same level of risk or less.
100% 14.3% 11.0%
Portfolios with Various Correlations
• Relationship depends on
correlation coefficient
-1.0 < r < +1.0
• If r = +1.0, no risk reduction is
possible
• If r = –1.0, complete risk
reduction is possible
The Minimum Variance Portfolio
• The minimum variance portfolio is the portfolio composed of
the risky assets that has the smallest standard deviation; the
portfolio with least risk
• The amount of possible risk reduction through diversification
depends on the correlation:
• If r = +1.0, no risk reduction is possible
• If r = 0, σP may be less than the standard deviation of either
component asset
• If r = -1.0, a riskless hedge is possible
The Efficient Set for Many Securities
return Individual
Assets
P
Consider a world with many risky assets; we can still identify the
opportunity set of risk-return combinations of various portfolios.
The Efficient Set for Many Securities
return
t ier
nt fron
c ie
effi
minimum
variance
portfolio
Individual
Assets
P
The section of the opportunity set above the minimum variance
portfolio is the efficient frontier.
Portfolio Risk and Number of Stocks
In a large portfolio the variance terms are
effectively diversified away, but the covariance
terms are not.
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable
risk; Systematic
Risk; Market Risk
n
Risk: Systematic and Unsystematic
• A systematic risk is any risk that affects a large number of assets,
each to a greater or lesser degree.
• An unsystematic risk is a risk that specifically affects a single asset or
small group of assets.
• Unsystematic risk can be diversified away.
• Examples of systematic risk include uncertainty about general
economic conditions, such as GNP, interest rates or inflation.
• On the other hand, announcements specific to a single company are
examples of unsystematic risk.
Total Risk
• Total risk = systematic risk + unsystematic risk
• The standard deviation of returns is a measure of total
risk.
• For well-diversified portfolios, unsystematic risk is very
small.
• Consequently, the total risk for a diversified portfolio is
essentially equivalent to the systematic risk.
Optimal Portfolio with a Risk-Free Asset
return
efficient frontier
rf Individual Assets
Consider a world that also has risk-free securities like T-
bills.
e r
onti
nt fr
ci e
i
eff
Riskless Borrowing and Lending
return
efficient frontier
rf
P
With a risk-free asset available and the efficient frontier identified,
we choose the capital allocation line with the steepest slope.
Tangent Portfolio
0 X=200%
X=5
%
X=150%
X=100
%
Market Portfolio
Market Equilibrium
return
L
CM efficient frontier
rf
P
With the capital allocation line identified, all investors choose a point along the line—
some combination of the risk-free asset and the market portfolio M. In a world with
homogeneous expectations, M is the same for all investors.
Market Equilibrium
L
return
CM
100%
stocks
Balanced
fund
rf
100%
bonds
Where the investor chooses along the Capital Market Line depends on her
risk tolerance. The big point is that all investors have the same CML.
Risk When Holding the Market Portfolio
• Researchers have shown that the best measure of the risk of a
security in a large portfolio is the beta (b) of the security.
• Beta measures the responsiveness of a security to movements
in the market portfolio (i.e., systematic risk).
Cov(Ri,RM )
i
(RM )
2
One useful property
• The average beta across all securities, when weighted by
the proportion of each security’s market value to that of
the market portfolio, is 1.
where Xi is the proportion of Security i’s market value to that of the
entire market and N is the number of securities in the market.
Estimating b with Regression
Security Returns
ine
L
st ic
c t eri
a ra
Ch Slope = bi
Return on
market %
Ri = a i + biRm + ei
The Formula for Beta
Cov(Ri,RM ) (Ri )
i
(RM )
2
(RM )
Clearly, your estimate of beta will depend
upon your choice of a proxy for the
market portfolio.
Relationship between Risk and Expected
Return (CAPM)
• Expected Return on the Market:
R M RF Market Risk Premium
• Expected return on an individual security:
R i RF β i ( R M RF )
Market Risk Premium
This applies to individual securities held within
well-diversified portfolios.
Expected Return on a Security
• This formula is called the Capital Asset Pricing Model
(CAPM)
R i RF i (R M RF )
Expected
Risk- Beta of Market risk
return on = + ×
free rate the premium
a
security
security
• Assume bi = 0, then the expected return is RF.
• Assume b = 1, then the expected return is Rm.
i
Relationship Between Risk & Return
Expected return
R i RF i (R M RF )
Rm
Rf
1.0 b
Relationship Between Risk & Return
13.5%
Expected
return
3%
1.5 b
i 1.5 RF 3% R M 10%
R i 3 % 1 .5 (10 % 3 %) 13 .5 %
The Security Market Line and the CAPM
• CAPM describes how the betas relate to the expected rates of
return. The key insight of CAPM is that investors will require a
higher rate of return on investments with higher betas.
The Security Market Line and the CAPM
SML is a graphical representation of the CAPM.
SML can be expressed as the following equation, which is often
referred to as the CAPM pricing equation:
E (rAsset j ) rf Asset j [E (rMarket ) rf ]
In the Pursuit of a perfect portfolio
• In the pursuit of a perfect portfolio – William Sharpe
• [Link]
END
