Capital Asset Pricing Model

Philippe Henrotte
HEC Paris
Topic 4: CAPM

The Tangent Portfolio

CAPM
The Market Model
Performance Evaluation
CAPM and Asset Pricing

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Topic 4: Roadmap
When we say that more risk should be rewarded by
more expected return (cost of capital), which risk are we
talking about?
Volatility / standard deviation / variance, or
Beta / covariance with the market?
How can we reconcile the fact that some stocks with
very large volatility seem to deliver consistently small
returns over long periods of time?
Should companies be rewarded for being well
diversified?
When would you say that a company over performs?
How would you measure the performance of a fund
manager?

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Introduction
Modern Portfolio Theory focuses on the asset allocation
problem of an isolated individual given asset expected
returns and (co)variances
CAPM aggregates the behavior of all investors and
describes the equilibrium relation between expected
returns and (co)variances (= risks)
CAPM is a general equilibrium model
CAPM is the central model of modern finance
Used to value securities
Used to determine the cost of capital
Used to evaluate the performance of a security

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The Tangent Portfolio
The Demand for Securities
Assume perfect markets (no transaction cost, tax, limit
on short sales)
Assume that all investors
are mean variance efficient (not too far fetched)
share the same opportunity set, i.e. can invest in the same
securities, risky and risk free (reasonable assumption)
share the same probability views about the future returns of the
securities (much harder to believe)
Then they all derive the same efficient frontier combining
the risky and the risk free security: the Capital Allocation
Line of the Tangent Portfolio
And they all choose a point on this efficient frontier

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Efficient Frontier
Efficient portfolios combining risky and risk free securities

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The Demand for Securities
The portfolio selected by each investor consists of
A fraction ωT of her initial wealth invested in the Tangent
Portfolio T with only risky securities
A fraction ωf = 1- ωT of her initial wealth invested or borrowed at
the risk free rate
The more risk averse investors invest a fraction of their
wealth at the risk free rate (ωT < 1)
while the less risk averse ones use leverage: they
borrow at the risk free rate and to invest more than their
initial wealth in the Tangent Portfolio T (ωT > 1)
The risky part of the portfolio of every investor is the
same Tangent Portfolio T

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The Demand for Securities
The amount invested in the Tangent Portfolio varies for
each investor for two reasons
it depends on his wealth
it depends on his risk aversion
Example: Let us assume that Mrs Smith owns in her
optimal portfolio 200 shares of the Walt Disney Company
worth $30 per share and 100 shares of Coca-Cola worth
$40 per share
Consider now the optimal portfolio of Mr Johns. Knowing
that he owns 100 shares of the Walt Disney Company,
how many shares of Coca-Cola does he also own?
Mr Johns owns 50 shares of Coca-Cola

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The Demand for Securities
If we gather the portfolios of all investors in a giant
portfolio, this aggregate portfolio is again the Tangent
Portfolio
This big portfolio corresponds to the aggregate demand
of investors for risky securities in the economy
In our example every investor should also own twice as
many shares of the Walt Disney Company as of Coca-
Cola
The aggregate portfolio has therefore also twice as many
shares of the Walt Disney Company as of Coca-Cola

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The Supply of Securities
The supply of risky securities in the economy is the sum
of all the risky securities which have been issued and
which are available for trading
The giant portfolio which consists of all the securities
which have ever been issued and which remain available
for trading is called the Market Portfolio
The portfolio weight of each security in the Market
Portfolio is proportional to its market capitalization: the
price of the security multiplied by the number of
securities which have been issued
The Market Portfolio describes the aggregate supply of
risky securities in the economy

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Equilibrium
An equilibrium obtains when supply equals demand, in
our case when the aggregate supply equals the
aggregate demand for risky securities in the economy
We have seen that the aggregate demand is the
Tangent Portfolio
And that the aggregate supply is the Market Portfolio
We conclude that at the equilibrium the Tangent
Portfolio is the Market Portfolio
This is a great result: we can now identify the Tangent
Portfolio without having to solve a complex optimization
problem

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The Capital Market Line

The Capital Market Line (CML) is the Capital Allocation

Line of the Market Portfolio
It is also the efficient frontier with risky and riskless
securities since we know that the Tangent Portfolio is
also the Market Portfolio

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The Capital Market Line
CAPM

An Equilibrium Model
CAPM
The CAPM (Capital Asset Pricing Model) uses the
optimality of the Market Portfolio (which we identified to
the Tangent Portfolio on the efficient frontier) to evaluate
the risk premium of every security as a simple function
of the risk premium of the Market Portfolio M, the market
risk premium
For every security i

with

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CAPM
CAPM shows that the risk that matters for pricing a
security is not its variance, but its covariance with the
Market Portfolio, or (more precisely) its Beta
CAPM quantifies the risk-return trade-off, it expresses
the expected returns of a security as a function of
systematic risk

expected return risk free rate risk exposure price of risk

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Beta

Beta measures how an individual security amplifies the

market movements
A security with large Beta magnifies the market
variations, it is therefore risky and requires a large risk
premium
A security with a small Beta dampens the market moves,
it is less risky and requires a small risk premium
The Market Portfolio itself has a Beta equal to one

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The Security Market Line

There is a linear relationship between the Beta of a

security and its expected return
According to the CAPM, if the expected return and Beta
for individual securities are plotted, they should all fall
along the Security Market Line (SML)

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The Security Market Line

Intercept: the
risk free rate
Slope: the
market risk
premium

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CAPM
Example: Assume CAPM holds, we are given the
following data
The risk free rate rf = 4%
EM = 10%, σM = 16%
σIBM = 30%, ρIBM,M = 0.8
Find the expected return EIBM of IBM

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CAPM
We first derive the Beta of IBM

We then use the CAPM equation

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Portfolio Beta
The Beta of a portfolio is the (value) weighted average of
the Betas of its securities

Remark: Since the Beta of the Market Portfolio is one,

the value weighted average of the Betas in the market is
one

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Historical Volatility and Return for 500 Individual Stocks,
Ranked Annually by Size
The CML and the SML

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The Market Model
Linear Regression
Consider two random variables X and Y
Say X is the amount of rain falling on Paris on a given day
And Y is the percentage of people in the streets of Paris on that
day carrying an umbrella
The linear regression seeks to predict Y from X in a
linear way

Or you may seek to account for past daily observations

assuming that they are drawn from the linear model
above

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Linear Regression
Alpha is the intercept: even without rain, some people
carry their umbrella (you never know)
Beta is the slope: we expect it to be positive if people in
Paris are a bit rational about the weather
Epsilon is the residual, the part which remains
unexplained by X
For a given level of rain, the fraction of people carrying an
umbrella remains variable from day to day for reasons unrelated
to the rain
It should be zero on average (otherwise change the intercept
Alpha)
It should not be correlated with X (otherwise change Beta)

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Linear Regression
Since X and the residual Epsilon are uncorrelated

and we conclude that

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Linear Regression
Again since X and Epsilon are uncorrelated

The total noise in Y is decomposed in two parts

The first part is the noise explained by X through Beta
The second part is unrelated to X
The R square of the regression is the percentage of the
total noise in Y explained by X

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Market Model

CAPM is about expected returns, but we only observe

realized returns
The linear regression of (realized) excess asset returns
on (realized) excess market returns is called the market
model
We can estimate the true CAPM Beta using the market
model

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Market Model
Y is the excess return on security i:
X is the excess return on the market portfolio:
We seek to explain Y by X linearly

Beta is the Beta of the regression (which explains its

name)

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Cisco and SP500

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Cisco and SP500 - Beta 1.6

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Betas with Respect to the S&P 500 for Individual Stocks (based on
monthly data for 2007–2012)
Betas with Respect to the S&P 500 for Individual Stocks (based on
monthly data for 2007–2012)
Market Model
The noise in Y is here the variance of the return of
security i which we decompose in two parts

Or

total risk idiosyncratic risk

market risk

CAPM says that only the market risk matters when

setting the cost of capital
The firm specific risk can indeed be diversified away

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Performance Evaluation
Market Model and CAPM

The residual as zero expectation, the market model

implies therefore

The CAPM can simply be stated as

for every security i

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Alpha
Alpha is also called the risk adjusted return
In equilibrium CAPM says that all securities should have
an Alpha equal to zero
A security with positive Alpha over-performs, it delivers
more expected return than required by its level of risk
and is therefore out of equilibrium
Investors should rush to purchase this security
As its price increases, its future expected return should
decrease and the Alpha should fall to zero, back to an
equilibrium

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Alpha
The opposite applies for a security with negative Alpha
It under-performs since it delivers a return lower than
required by its level of risk
Its price should fall as investors sell it
As its price falls, expected return increases and brings it
back to equilibrium with zero alpha

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Performance Evaluation
For a single security, the volatility is not a good
measure of risk since a fraction of it can be diversified
away
The right measure of risk is Beta and the measure of
performance is Alpha
For a diversified fund, the volatility is a good measure
of risk, its performance is measured by its Sharpe ratio
Volatility and Sharpe ratio should not be used to
evaluate a single security

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CAPM and Asset Pricing
CAPM and Asset Pricing

Recall from Topic 2 that NPV is used to value a stream

of cash flows once we know the appropriate discount
rate r

CAPM gives the appropriate discount rate r for security i

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