Managerial Finance

Capital Asset Prices: Risk and Return

G.H. Lawson Richard Pike
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G.H. Lawson Richard Pike, (1979),"Capital Asset Prices: Risk and Return", Managerial Finance, Vol. 5 Iss 1 pp. 42 - 56
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 42 | Managerial Finance 5,1

Capital Asset Prices: Risk and Return

by G. H. Lawson and Richard Pike

Introduction
Though of fairly recent origin, the capital-asset pricing model (CAPM) is becoming a
dominant influence in the analysis of financial and investment decisions. While
continuing to undergo stringent theoretical and empirical examination, the demon-
strable explanatory and predictive ability of the CAPM have led to its widespread
recognition as the foundation of modern financial management. Though usually
attributed to Sharpe[l], Lintner[2] and Mossin[3], the origins of the CAPM can be
traced back to the celebrated work of Harry Markowitz[4] on portfolio selection.
The substance of the CAPM is that in efficient markets the price of, or return
(dividends plus (minus) share price appreciation) expected from securities and assets
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is a linear function of their characteristic degrees of so-called market risk. Market

risk is measured by a beta coefficient and may, in turn, be interpreted as the responsive-
ness of the prices of, or returns from, individual securities to changes in the average
price of, or returns from, the entire population of marketable securities (market
portfolio) and assets. The best known version of the CAPM is thus:

where,
is the single period rate of return expected by an investor from a risky asset or
equity share and is in turn given by (The symbols P0,
define entry and expected exit values respectively, and is the expected
end-period dividend);
i is the one-period riskfree interest rate, e.g. the one-year rate of interest obtainable
on a government security;
is the expected one-year rate of return on the market portfolio.
The CAPM is based on a number of specific assumptions, the principal of which are
enumerated below. Thereafter we outline the main elements of the model and then
consider its impact on portfolio theory, security analysis and corporate financial
management.

Assumptions
The main assumptions underlying the CAPM are:
(1) Investors base their portfolio investment decisions on the Markowitz expected
return (profitability) and variance (risk) criteria.
(2) Investors have homogeneous expectations, i.e. all investors ascribe the same
probability distribution to the returns from the same investment. These prob-
ability distributions do however differ from one investment to the next.
 Capital Asset Prices | 43

(3) Investors may borrow and lend without limit at the riskless interest rate.
(4) Capital markets are in equilibrium, i.e. there is neither excess supply nor
excess demand at the asset and security prices which rule in the market place.
(5) Market efficiency is characterised by infinitely divisible securities (or assets),
costless information and the absence of both taxes and transactions costs.
It may rightly be questioned why a model should be based on assumptions, some of
which are patently unrealistic or restrictive. In most model-building processes it is
usually helpful to begin with simplifying assumptions if only to get things under way.
Conclusions having first been derived under restrictive assumptions, such conditions
can then be relaxed by degrees in an attemptfinallyto establish a model's explanatory
power and predictive ability at a higher level of generality. Whilst, as already implied,
the operational usefulness of the CAPM has been verified to a rare degree, we never-
theless maintain the above assumptions hereafter for simplicity of exposition.
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Portfolio Risk Reduction

Portfolio theory is concerned with efficient portfolio selection, that is, with the choice
of efficient combinations of assets and/or securities. Most investors instinctively
recognise that efficient investment is as much concerned with risk as with return and
attempt to construct portfolios that are consistent with their individual risk preferences.
In general, investors will require commensurate compensation for risk borne and the
supply and demand for risky investments can be expected to result in prices and ex-
pected returns which reflect the situation accordingly. At any given risk level, the
optimal portfolio is that which promises the highest expected return. Conversely, at
any pre-defined expected rate of return, optimality is defined by the risk minimising
portfolio.
Portfolio selection may be described as the choice of a portfolio that lies on the
locus, the so-called efficient frontier, of the points depicting the highest possible
portfolio return at any given risk level. In that any portfolio comprises securities held
in different, or for that matter equal, proportions, portfolio selection may, in turn,
be said to be the choice of the proportions of some combination of securities in the
attempt to attain optimality in the above sense.
As already implied, risk in a portfolio context is measured by the dispersion of
possible portfolio returns (capital appreciation/depreciation and dividends) about
their expected value. It is risk of this nature, that is, total risk as opposed to market
risk, that can be reduced by the portfolio diversification process. The nature of total
risk has long been recognised by such maxims as "don't put all your eggs in one
basket". However, as shown in the seminal paper by Markowitz, the total risk of
investments accepted in combination depends upon the degree to which their possible
outcomes are correlated, and it is not merely a question of relying on the law of large
numbers. Thus, the risk-spreading portfolio diversifier needs to be aware of the
interaction between investments and the resultant effect on portfolio risk.
 4 4 | Managerial Finance 5, 1

A more incisive insight into the nature of portfolio selection and risk diversification
is afforded by the example of a portfolio of two risky securities, a and b, held in the
respective proportions w and 1 w. The expected rate of return, on such a portfolio
is given by:

where, and are the expected rates of return on securities a and b respectively.
The portfolio risk measured by the standard deviation of the expected portfolio
rate of return is given by:

where,
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are the standard deviations of the expected rates of return of securities

a and b respectively; and,
cov. is the covariance of the returns to securities a and b.
The size and sign of the covariance term, cov. indicate the extent, and direction,
in which the possible returns to securities a and b are correlated. If divided by the
product, the latter covariance is converted into the more familiar correlation
coefficient, Rab. If the possible returns to any pair of securities, a and b, are perfectly
positively correlated, Rab will take on a value of unity. If their possible returns are
completely independent, Rab will be zero, whereas perfect negative correlation would
be represented by Rab = 1.
In general, the returns to any pair of risky securities can be assumed to be positively
correlated since all security prices are affected to a greater or lesser degree by the same
set of psychological, political and economic influences. Portfolio diversification
nevertheless affords clear opportunities for risk reduction. For example, assume that
securities a and b offer expected returns of 14 per cent and 20 per cent respectively.
Assume also that the standard deviations of these expected returns are = 8 per
cent and = 10 per cent and that their correlation coefficient, Rab, is 03. The
covariance, cov. is therefore
cov. (ra, rb) =
= (03) (008) (01)
= 0 0024.
To determine the proportions in which a and b should be combined in order to
minimise the portfolio risk, it is merely necessary to put the values of and
cov. into equation (3) and to differentiate with respect to w, setting the derivative
equal to zero.
 Capital Asset Prices \ 45

Thus,

whence the minimum value of w is 065. The minimum portfolio risk, that is
possible with this pair of securities is therefore:
= [(065)2 (008)2 + (035)2 (01)2 + 2(065) (035) (00024)]1/2
= 00709 (i.e 71%).
At the minimum risk level, the portfolio expected rate of return, is thus
= (065) (014) + (035) (02)
= 0161 (i.e. 161%)
By combining securities whose possible returns are positively correlated it is therefore
often possible to attain a portfolio risk which is lower than the individual risk levels
of each of its constituent investments. By contrast, the portfolio expected rate of
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return, is the weighted average of the constituent rates of return and will always
lie between the highest and lowest constituent rates of return.
The simple example of two securities in combination can readily be extended to
any multi-security portfolio. Empirical work by Fisher and Lorie[5] suggests that a
relative risk reduction of 57 per cent can be achieved for randomly chosen portfolios
that have the same expected return as that of a typical equity share. They also demon-
strate that the benefits from diversifying across more than 16 shares held in equal
proportions are negligible. Their results are illustrated in Figure 1.

Riskfree Securities and the Capital Market Line

The efficient frontierthe locus of the highest possible portfolio return at any given
risk levelis illustrated in Figure 2 by the curve AB. All securities and portfolios
which are to the right of the efficient frontier are by definition less than perfectly
diversified. In the absence of securities other than risky securities, an investor will select
the portfolio on the efficient frontier which maximises his utility. The portfolio yielding
maximum utility would be at the point of tangency (T in Figure 2) between the efficient
frontier and the highest attainable indifference curve in the investor's indifference
map.
The indifference map shown in Figure 2 is based on two principal assumptions.
First, that the investor is risk averse, i.e. he requires a rate of return that is increasing
at an increasing rate to compensate for total risk that is increasing at a constant rate.
Second, that given the level of risk, the investor will prefer the portfolio offering the
highest rate of return.
If, as is one of the explicit assumptions on which the CAPM is based, the investor
also has access to such riskfree securities as Treasury bills and other government
stocks and can also borrow at the riskfree interest rate, he is able to construct each
of the array of portfolios depicted by the line CML (the capital market line) in Figure
 46 | Managerial Finance 5, 1

Figure 1. Portfolio Diversification and Risk Reduction

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As Figure 1 suggests, there is some element of individual security total risk that cannot
be eliminated by diversification. Such non-diversifiable risk, alternatively known as
systematic or market risk, is attributable to psychological, political and economic
factors which, as already mentioned, explain the positive correlation between the
returns to risky investments. Put another way, diversification can never wholly
eliminate the returns to securities that are positively correlated because, as indicated
by equation (3), the presence of a positive covariance term means there is no set of
proportions, w1, w2,. . . , at which the value of will become zero.
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Capital Asset Prices | 4 7

 48 | Managerial Finance 5, 1

2 which dominates the efficient frontier. At the one extreme, he could invest all his
wealth in riskfree securities, whilst at point M he holds an all-equity portfolio. Between
these two limits, the investor can achieve the various combinations of a riskfree
investment and portfolio M that are described as lending portfolios. The CML is a
tangent drawn from the riskfree interest rate, i, to the efficient frontier. The tangency
point portfolio M is the so-called market portfolio and in theory is the universally
desired optimal portfolio containing all risky securities in proportions reflecting the
total equity values of the companies they represent. By combining the market port-
folio M with a riskfree security, an investor who was originally at point T on the
efficient frontier could move vertically upwards to a point on the CML which offers a
higher return for the same risk level. But as Figure 2 shows, the nature of his in-
difference map may be such that he obtains a higher utility by combining the market
portfolio and a riskfree security in the proportions indicated by the point P. At this
point, his higher utility is represented by a significantly lower risk at much the same
rate of return.
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If the investor is able to borrow money at the same riskfree interest rate at which he
can invest, he can supplement his available capital and construct a "borrowing"
portfolio which is located on the CML to the right of the market portfolio M. If the
borrowing rate is higher than the lending rate, the CML is defined by i MVX, where
VX is the tangent from the (higher) borrowing rate to the efficient frontier.
If capital markets are efficient and investor behaviour is consistent with the assump-
tions which underlie the CAPM, all will hold a portfolio on the CML. Their precise
choice of position on the CML will depend upon their individual utility functions
which collectively represent the supply and demand conditions for both risky and
riskfree securities. But all investors will hold a portfolio comprising some ratio of
the market portfolio, M, and a riskfree security. This is another way of saying that
an investor's choice of risk level can be separated from the problem of an optimal
combination of risky securities. This proposition is known as the separation theorem
and is attributable to James Tobin[6]. Although the concept of the market portfolio,
which is the basis of the separation theorem, is central to the CAPM, it does not exist
in reality. In practice, the market portfolio is proxied by such market indices as the
FT All-Share Index or the de Zoete and Bevan Equity Index, etc.
As the description of Figure 2 makes clear, the CML is a linear function. Hence,
portfolio risk can be described as a linear function of the proportion of funds invested
in the market portfolio. For example, if one-third of an investor's wealth is deployed
in a riskfree security and the remainder is invested in the market portfolio at a risk,
of (say) 12 per cent, the total portfolio risk, borne will be:
= (1 033) (012)
= 008 (i.e. 8%).
Similarly, if the riskfree interest rate,i,and the expected rate of return, on the market
portfolio are 10 per cent and 18 per cent respectively, the portfolio rate of return,
 Capital Asset Prices | 49

is:
(033) (01) + (067) (018) = 01533 (i.e. 151/3%).
Were the investor's wealth to be divided in the respective proportions 025 and 075,
the corresponding risk, and expected rate of return, rp, would be:
= (075) (012) = 009 (i.e. 9%)
and, " = (025) (01) + (075) (018) = 016 (i.e. 16%).
The equation for the capital market line, which can be inferred directly from Figure
2, is:

(4)

where,
is the expected rate of return from any portfolio on the CML;
i is the riskfree interest rate;
is the expected rate of return on the market portfolio;
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is the total risk of the market portfolio; and,

is the total risk of a portfolio on the CML.
The rate of return, expected from a portfolio on the CML thus comprises two
elements, namely, the riskfree interest rate, i, and a total risk premium. The latter is
given by the market price of risk, which also defines the slope of the
capital market line, multiplied by the totalrisk,(r)p,of the portfolio in question. To
illustrate the nature of the CML by direct reference to the CML equation, let i = 11 %,
= 16%, and = 6 % . If an investor desires a risk level of 4 per cent, that is, a
portfolio which is two-thirds as risky as the market portfolio, his expected rate of
return, will be given by:

A portfolio offering this performance is clearly one which comprises ariskysecurity and
the market portfolio in the proportions 033 and 067 respectively.
Assume that a second investor will maximise his utility at a 10 per cent risk level
which exceeds the risk of the market portfolio. He therefore requires a borrowing
portfolio. His expected rate of return, is:

Tofinancea portfolio yielding this rate of return, the investor would need to borrow
at the riskfree interest rate, an amount representing the proportion w of his investable
resources which satisfies the equation:
0193 = w(011) + (1 + w)(016)
whence, w = 067 (i.e. two-thirds of his investable resources).
 50 | Managerial Finance 5, 1

Individual Securities and the Security Market Line

In that the market portfolio is the sole example of a perfectly diversified risky portfolio
that can be efficiently combined with a riskfree security in either a lending or borrowing
portfolio, all other portfolios and individual securities must lie below the capital
market line. To hold individual risky securities or imperfectly diversified portfolios
is inefficient because diversifiable or specific risk can be eliminated by further diversi
fication. The prices of risky securities, and the expected returns thereto, therefore
compensate for non-diversifiable or market risk alone since the market will not reward
that which can be obviated.
A major component of a security's expected return reflects the sensitivity of its
price to market movements as a whole since all enterprises are affected to a greater
or lesser extent by the political and economic outlook, etc. Share price fluctuations
that are not related to general market movements tend to occur at random and reflect
such events, e.g. technological breakthroughs, strikes and mismanagement, etc., as
are peculiar to an individual firm. This specific risk can be eliminated by diversification
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precisely because of its random character. Since only the market risk component of
a security's total risk is impounded in its price, it follows that the equation for an
individual security that is analagous to the equation for the CML will embody no
more than a premium for market risk.
In that the market risk, of any individual security, e, expresses the degree to
which its possible returns covary with, i.e. are correlated with, the possible returns to
the market portfolio, M, it is given by:

where
is the variance of the return expected from the market portfolio;
Rtm is the coefficient of correlation between the possible returns to e and M;
and
are the standard deviations of the returns to e and M.
The expected rate of return, on an individual security is thus:
 Capital Asset Prices \ 51

Equation (1) is also the equation for the so-called security market line (SML) and is
derived from an analysis of a portfolio comprising a risky security e and the market
portfolio, M, in varying proportions.
By definition, the beta value for the market portfolio is unity since:

An individual security with a beta of one will, on average, move in line with the
market and offer an expected rate of return which is equal to the expected rate of
return, on the market portfolio. A beta of 05 indicates a low risk security which
responds by only 05 per cent to a 1 per cent movement in the market. A security
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Figure 3 Security market line (SML).

 52 | Managerial Finance 5, 1

with a beta of 15 is characterised by a relatively high degree of market risk and will,
on average, respond by 15 per cent to a 1 per cent market change.
Stocks with betas below one are termed "defensive" securities since they rise less
rapidly than the market in a "bull" market and fall less rapidly in a "bear" market.
Stocks with betas exceeding one are classified as "aggressive" securities.
Like the CML, the SML is also a linear function and may be illustrated as in
Figure 3. The intercept of the SML denotes the riskfree interest rate i, whereas its
slope measures the market's premium for risk. In theory, all securities and all port
folios lie on the SML since their expected returns are a linear function of market
risk. Should a security emerge which offers a return above the SML, market efficiency,
represented by a process akin to arbitrage, will ensure that its abnormal yield is
quickly eliminated. Thus, the excess demand for such a security will rapidly raise its
price, thereby lowering its expected return, until it is brought back on to the SML.
The SML differs from the CML in that the latter depicts the expected return from
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perfectly diversified portfolios expressed as a function of (portfolio) total risk. By

contrast, the market risk compensated by the expected return (defined by the SLM)
on an individual security represents the non-diversifiable component of that security's
total risk as measured by cov. The total risk of a perfectly diversified
portfolio, or of any other portfolio or security, defines the dispersion of possible
returns thereto about their own expected value. Only in the case of perfectly diversified
portfolios are total risk and market risk synonymous. This can readily be seen by
comparing the definitions of total risk and market risk for an individual security on
the one hand and for the market portfolio on the other.
The total risk measured by the variance, (standard deviation squared), of any
portfolio or security e is given by:

where p, denotes the probability of the outcome, rc.

Substituting for the covariance, cov. the beta coefficient, p is given by:

where Pm denotes the probability of a joint outcome re + rm.

Multiplying (7) by since merely serves to normalise the market risk on the
market portfolio i.e. allows m to be expressed as unity, the corresponding measures
 Capital Asset Prices | 53

of total and market risk on the market portfolio are:

Hence ,
It also follows that in partitioning a security's total risk, diversifiable risk may be
expressed as:
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Application to Capital Budgeting

There are clear affinities between a portfolio which comprises individual securities
and afirmviewed as a collection of capital projects. Prior to its adoption, each invest-
ment proposal has a cost of capital (or required rate of return) which may be represented
as a function of the proposal's perceived degree of market risk. A project's cost of
capital is therefore defined by equation (1) and each has its own beta coefficient.
Whilst the estimation of project beta coefficients is no easy matter, the problem ought
nevertheless to be faced. Capital project analysis based on a sound theoretical frame-
work may generally be assumed to elucidate more fundamental implications of
corporate policy and strategy than those directly related to individual projects.
Project beta estimates can be based on published security betas[7]. An individual
project may be regarded as a microcosm of some other company, or as being repre-
sentative of some other company to an extent that the two may tolerably be assumed
to have the same degree of market risk. In any event, a quoted company may use its
own beta balue, which by definition is the weighted average of the betas of all existing
projects, as the beta for the "average" type of project undertaken. Other investment
proposals can then be classified in accordance with the sensitivities of their operating
costs and revenues to unanticipated changes in general economic conditions [8] by
reference to the "average". Alternatively, in that the beta value of an average project
in the economy as a whole is equal to unity, and that of a riskfree project is equal to
zero, the betas of projects which are of sub-average risk from a general economic
standpoint might be estimated accordingly. Similarly, in that published beta co-
 54 | Managerial Finance 5, 1

efficients for companies do not take on values exceeding 15, projects which are of
above average market risk (for the economy as a whole) might be ranked on a scale
from 1 to 2 (thereby allowing for project beta dispersion about the company upper
beta value of 15).

Implications for Investors

The CAPM has already elucidated many areas of security analysis. Advances in the
analysis of stock market securities can in fact be counted among the early practical
applications of the CAPM. The simplification achieved by using a market index as a
surrogate for the market portfolio is a case in point. The application of the original
Markowitz model is both complex and laborious. For example, to calculate the variance
(total risk) of a portfolio containing 100 securities, it is necessary to compute 100
variances and 4,950 covariances. The simplified model developed by Sharpe reduces
the data requirement to 302 items for the same portfolio. Cohen and Pogue[9] have
demonstrated empirically that the use of an index gives broadly the same results as the
full Markowitz model. Portfolio risk can now be readily estimated since it is simply
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the weighted average of the beta values of its constituent investments and such values
for over 2,000 British securities have recently become available[7].
If market risk alone is embodied in security prices, it follows that there may be
many securities of relatively low market risk but which have been issued by companies
that have a high bankruptcy (total) risk. Somewhat paradoxically, such securities will
offer relatively low expected returns and have relatively high prices. The explanation
is simply that individual investors can largely obviate bankruptcy risk by adjusting
their portfolios. In reality, bankruptcy risk cannot be wholly diversified away because,
in the event of bankruptcy, the market values of securities are unlikely to be fully
realised. In other words, there are certain costs associated with the possibility of
bankruptcy, for which investors require compensation and a security's expected rate
of return will reflect the situation accordingly.

Further implications for financial managers

As outlined in the previous pages, the rate of return expected from any investment
is commensurate with its characteristic degree of market risk and a firm's cost of
capital is therefore defined by equation (1). A firm's cost of capital may also be
described as the capitalisation rate which discounts its expected (proprietorship)
cash flows to equality with its market value. The one-period valuation model of the
firm which integrates risk and profitability in the same framework is thus:

(10)
 Capital Asset Prices \ 55

where
V0 is the market value of a one-period firm at end-year 0;
is the proprietorship cash flow expected at the end of period 1; and,
is the capitalisation rate that is commensurate with the firm's degree of market
risk, e.
The CAPM therefore specifies the basis on which a firm's risk-adjusted cost of capital
should be quantified in attempting to determine its value as a going concern. Whilst
the only valuation problems that are of interest to financial managers are those of a
multiperiod character, the single-period model offers the most rigorous available
theoretical framework for takeover and merger analysis. Multiperiod extensions of
the CAPM are in fact already amenable to practical use.
The CAPM has important implications for corporate risk policy. If, following the
prescription advocated above, a project's cost of capital only allows for market risk,
it is important to question the ultimate effect on a firm's total risk. In fact, as already
observed, a policy of relatively low market risk may be entirely consistent with a high
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total risk, and therefore a high likelihood of bankruptcy at the corporate level. Port
folio adjustments by shareholders will countervail bankruptcy risk in which case
internal (project and product) diversification aimed at a reduction in total risk is of
no advantage to proprietors.

Predictive Ability
The practical value to investors and corporate managers of any model depends mainly
upon its predictive ability. The predictive power of the CAPM depends primarily upon
the accuracy of estimates of ex ante beta coefficients. In practice, this problem is
usually resolved by resort to ex post beta values. To what extent should historic
betas be used as a surrogate for future beta coefficients? Sharpe and Cooper[10],
Blume[ll], Fama[12] and many others have rigorously examined the stability of beta
values over time.
There is a strong consensus that portfolios with a wide variety of securities, say at
least 50, have relatively stable beta values from year to year. Conversely, individual
securities and poorly diversified portfolios have very unstable betas over time. It
seems sensible to assume that, whilst it may be reasonable to use beta values for
forecasting the market risk of larger portfolios, the estimation of individual security
or project betas from historic betas may be fraught with considerable danger. In
other words, in the absence of diversification, we can be much less sure of the stability
of beta values over time.
Resume
In this article, we have attempted to summarise the principal facets of the capital-asset
pricing model and to indicate some of the practical problems on which it has thrown
important light. The concept of market risk, its measurement by the beta coefficient,
and thus the specification of the risk-adjusted discount rate are arguably the most
important results that emerge from the CAPM.
 56 | Managerial Finance 5, 1

In re-emphasising the character of such underlying assumptions as homogeneous

investor expectations and highly efficient capital markets, it should also be repeated
that the model is in fact more generally valid. Its underlying assumptions are never-
theless subject to continuous theoretical examination and empirical testing, and will
doubtless be subject to further revision in the fullness of time. The capital-asset pricing
model has not only shaken the foundations of financial and capital market theory, it
has several crucial implications for investors and financial managers alike. In the
next decade, its full practical potential is likely to be revealed.

Bibliography
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The Journal of Finance, 1964.
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and capital budgets", The Review of Economics and Statistics, 1965.
3. Mossin, J., "Equilibrium in a capital asset market", Econometrica, 1966.
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4. Markowitz, H., "Portfolio selection", The Journal of Finance, 1952.

5. Fisher, L. and Lorie, J. H., "Some studies of variability of returns on investments in common
stocks", Journal of Business, 1970.
6. Tobin, J., "Liquidity preference as behaviour towards risk", Review of Economic Studies, 1957/8.
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