Financial Management 2

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Capital Asset Pricing Model and Modern Portfolio Theory

Capital Asset Pricing Model and Modern

Portfolio Theory

The topics we will discuss in this module include the basics of capital asset
pricing model and modern portfolio theory.
After studying this module, the students should be able to
1. Understand the basics of capital asset pricing model.
2. Understand the two types of risks that CAPM deals with.
3. Understand the basic concept of beta coefficient, portfolio beta
coefficient, and security market line.

Introduction
Capital Asset Pricing Model and Modern Portfolio Theory (CAPM) is widely
applied throughout finance for the pricing of risky securities, calculating
expected returns for risky assets, and computing cost of capital. Investors
cannot get rid of the investment risks even if they tried to expand their
investments. And they deserve a compensation for accepting these risks.
(We will not be covering CAPM in minutiae since this is discussed fully in a
course in investment. We will just dwell simply on the basic CAPM basic
principles.)

Capital Asset Pricing Model (CAPM)

Capital asset pricing model was devised by William Sharpe, a financial
economist and a Nobel laureate in Economics. He featured this in his book
“Portfolio Theory and Capital Markets” in 1970.
CAPM begins with the idea that investment covers two types of risk:
1. Systematic risk - also called undiversifiable risk, this risk is market risk.
Factors that affect systematic risk are interest rates, recessions and wars,
inflation, business cycles, fiscal and monetary policies. These risks are
undiversifiable because it simultaneously affects all companies.
2. Unsystematic risk or specific risk – also categorized as diversifiable risk,
is one specific to individual shares and can be diversified away as the
investors increase his shares in the portfolio. Technically, it stands for the
component of the stock’s returns that is not correlated with the moves of
the general market. Factors affecting this risk include lawsuits, strikes,
management of the firm, operating and financial leverage, and other
events that are distinctive of a particular firm.
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Capital Asset Pricing Model and Modern Portfolio Theory

The modern portfolio theory presents that specific risk can be eliminated
through diversification. Nonetheless, the dilemma is diversification does not
solve the problem of systematic risk; even a portfolio of shares in the stock
market can’t eliminate this risk. Systematic risk afflicts investors most when
they calculate the warranted returns.

The capital asset pricing model (CAPM) is a model that describes the
relationship between systematic risk and expected return for assets,
particularly stocks.

CAPM Formula
Sharpe disclosed that the return on an individual stock or a portfolio of
stocks should equal its cost of capital. The following formula describes the
relationship between risk and expected return:

Investors need to be compensated in two ways: time value of money and

risk. Generally, this is idea behind CAPM. Time value of money is
represented by the risk-free rate (rf) in the formula.
The other half of the formula represents the risk and computes the
investors’ needed amount of compensation for putting their wealth in any
investment over a period of time. This is calculated by taking a beta that
compares the returns of the asset to the market over a period of time and to
the market premium (Rm-rf) - the return of the market in excess of the risk-
free rate.

Example of a Problem which requires determination of required rate of

return using CAPM approach.

RST Company’s beta coefficient of 1.8. The present rate of return on

Treasury securities is 10%. An analyst’s estimate the return on the market
portfolio is 12%.
Required:
1. The investor required rate of return in investing in a risk-free asset.
2. The components of the risk-free rate of return.
3. The price per unit of risk.
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4. The quantity of risk or beta.

5. The investor’s rate of return needed to invest in RST.
6. The additional return needed to move from a risk-free asset with zero
risk to an asset with 1.8 units of risk.
7. If the risk increased by .9 units, the required rate of return by the
investor.

Answers:
1. The investor’s required rate of return in investing in a risk-free market is
10%
2. The composition of the risk-free rate of return is the rate of interest that
will make the investor to defer consumption and the inflation premium
as protection versus rising price levels.
3. The price per unit of risk or beta is 2 %. (Return on market portfolio
less current rate of return: 12%-10%)
4. The quantity of risk is 1.8.
5. The investor’s required rate of return to make investment in RST is
13.6%. (computation: 10% + (12%-10%)1.8)
6. The additional return needed by the investor to move from a risk-free
asset with zero risk to an asset with 1.8 units of risk is 3.6%.
[computation: (12% -10%)1.8]
7. The required rate of return by the investor if the risk is increased by .9
units is 15.4%. [computation: 10% + (12%-10%)(1.8+.9)]

Beta Coefficient Concept

Beta, also known as beta coefficient, is a measure of the volatility or
systematic risk, of a security or a portfolio in comparison to the market as a
whole. It is applied in the CAPM in calculating the expected return of an asset
based on its beta and expected market returns.
Regression analysis is used in computing the beta. It represents the
propensity of a security’s return to counter the fluctuations in the market.
The beta of a security is computed by dividing the covariance the security
returns and the benchmark’s (market portfolio) returns by the variance of
the benchmark’s returns over a specified period. Covariance is an absolute
statistical measure of two variables.
To simplify, the formula for beta coefficient is

Covariance of Market Return with Stock Return

β=
Variance of Market Return

Correlation Coefficient Standard Deviation of Stock Returns

β= ×
Between Market and Stock Standard Deviation of Market Returns

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A security’s beta should only be applied when a security has a high R-squared
value in relation to the standard. The R-squared value is a statistical measure
representing the fund’s percentage or security’s movement which can be
explained by the movement in a benchmark index. R-squared, also known as
coefficient of determination shows how close the data are to the fixed
regression line. When using beta to establish the degree of systematic risk, a
security with the high R-squared value, in relation to the standard or
benchmark would add to the correctness of the beta measurement.

Estimating Beta Coefficient

Given the following suppositions: correlation coefficient between market and
share price of a RST Company is .80, standard deviation of market is 16% and
share price is 10%. The beta is calculated as follows: .80 x 10%/16% = .50
If the above variables for estimating the beta are not given from raw data, we
can follow these simple steps to estimate beta:
1. Get historical share price data for the company’s share price.
2. Find historical values of an appropriate capital market index, example is
S&P500 (you can check the net for this).
3. Convert the share price values into daily return values by applying the
formula: Return = (closing share price-opening share price)/ opening
share price.
4. Convert historical stock market index values using the same way in
number 3
5. Align the share return data with index return such that there is a 1-on-1
correspondent between them.
6. Using Slope function to get the slope between both arrays of data.
7. The resulting figure is beta.

Portfolio Beta Coefficient

The beta of a portfolio is the weighted sum of the individual asset betas. It is
measure of portfolio’s volatility. A beta of 1 implies that the portfolio is
neither more nor less risky that the wider market while a beta of greater
than 1 indicates greater instability and a less than 1 beta means less
volatility.
Portfolio beta is computed by adding the products of each security’s beta
multiplied by the proportional weight of the security in the portfolio.
Example: A portfolio consisting of three securities, one has a value of P
25,000 and a beta of .8, the second one valued P 15,000 with a 1.2 beta, and
the third security was valued at P10, 000 with a 1.1 beta. The portfolio beta is
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.98, computed as follows: (.8) (P25, 000/P50, 000) + (1.2) (1

P15, 000/P50, 000) + (1.1) (P10, 000/P50, 000) = .98

Such a portfolio will be less risky than the market and will experience a slight
price swing and relatively lower rate of return fluctuations.

Assuming a prevailing market return of 12% and a risk-free rate of 6%, the
investor can expect a rate of return of 11.88%, computed as follows: 6% +
(.98)(12%-6%) = 11.88%
If a higher rate of return is desired, increasing investment in the portfolio has
to be made, but then, expect higher risk.

Risk and Rate of Return Relationship

Generally, risk and rate of return are directly related, if the level of an
investment risk increases so with the possible returns on that investment.
We have applied the risk and rate of return relationship in the capital market
analysis but the same applies to much business decision-making like product
mix, marketing strategies, etc.
The capital asset pricing model states this risk-return relationship using beta
as the applicable risk measure. The required rate of return on a risky asset
consists of risk-free rate and a premium for systematic risk.

Again, the CAPM formula is stated as follows:

ra =required or expected rate of return

 The risk-free rate of return is the return expected of a security with
no systematic risk and measured by the yield on short-term treasury
securities like Treasury bills.
The risk-free rate is composed of (a) a real rate excluding inflation
probabilities and (b) inflation premium which equals the anticipated
inflationary rate.

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The risk-free rate and inflation premium changes in the same

direction and by the same amount. The required rate of return on all
securities will increase if the risk-free rate and inflation expectations
changes.
 The risk premium is the return needed in excess of the risk-free rate
and due also to systematic risk. The specific security’s risk premium
will be different from the market risk premium (which is a part of the
risk premium) if the beta of an individual security does not equal to
1.0.
Illustrative Problem 7.1 Portfolio Required Rate of Return –CAPM Approach
Given the following:
Stock A Stock B
Beta 1.8 .6
Risk-free rate: 10%
Expected return on the market: 15%

Required: the required rate of return

Solution:
Stock A
Required rate of return = .10 + (1.8) (15%-10%)
= .10 + .09
= 19%
Stock B
Required rate of return = .10 + (.6) (15%-10%)
= .10 +.03
= 13%
Stock A needs a 19% rate of return and a higher risk premium of 9%.
Stock B requires a 13% rate of return with a low risk premium of 3%
The market risk premium here is the basis of saying that the risk- premium is
high or low. In our problem, the market risk premium is 5% or (15%-10%),
which represents the risk premium on average security.

Security Market Line

Security market line (SML) is the graphical/linear representation of the
CAPM, showing the expected rate of return of an individual security as a
function of systematic risk. It basically graphs the outcome of the CAPM
formula.
On the X-axis, the risk or beta was plotted and on the Y-axis, the expected
return. The market risk premium is defined from the slope of the SML. The
intercept is the nominal risk-free rate available for the market, and the slope
is the market premium [E(Rm) – Rf].
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Figure 1. The Security market Line

The SML is a helpful tool is establishing if an asset for consideration to a

portfolio proposes a reasonable required return for risk. The individual
securities are plotted on the SML graph. If the expected return against risk is
above the SML, it is undervalued and the investor should expect a higher
return for the intrinsic risk. If the security is plotted below the SML, it is
overvalued and the investor would be accepting a lower return for the risk
assumed.

Expected values for the SML are calculated with the following equation:

Es = rf + Bs(Emkt - rf)
Where: rf = the risk-free rate
Bs = the beta of the investment
Emkg = the expected return of the market
Es = the expected return of the investment

Sample Cases/Questions on SML

1. RST Corporation’s beta is 1.8. The current rate of return on treasury
securities is 10%. An estimate of the return on market portfolio yields
12%, what is the required RST’s rate of return? And what is the price per
unit of risk?
Answers: RST’s rate of return = 10% + (12%-10%) (1.8) = 13.6%
Price per unit of risk is 2% or 12%-10%
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2. If the investors of RST became more risk unwilling or averse and the rate
of return on an average risk equity (beta=1) increase to 15%. What
would be the new expected rate of return for RST? What is the unit price
of risk? How the SML does behave?
Answers: RST’s rate of return = 10% + (15%-10%) (1.8) = 19%
Price per unit of risk is 5% or 15% -10%
SML’s behavior: upward rotation
3. On the other hand, if the investors became less averse and the market
portfolio dropped to 10.5%, what would be the expected rate of return?
How does the SML moves? What is the price per unit of risk?
Answers: RST’s rate of return = 10% + (10.5% -10%) 1.8 = 10.9%
SML‘s movement: rotates down
Price per unit of risk = .5%
4. If the consumer price index (CPI) increased by 2, what would be the
required rate of return? What is the price per unit of risk? What happens
to the SML?
Answers: Required rate of return = 10% + (14%-10%) 1.8 = 17.2%
Price per unit of risk = 4%
SML shifts up parallel.

References and Online Supplementaries

Book References
Brigham, Eugene, Houston, Joel (2012) fundamentals of Financial
Management, South-Western Cengage Learning, Ohio, USA.

Cabrera, Ma. Elenita Balatbat (2015) Financial Management, Principles and

Applications, Vol. 2. GIC Enterprises Co. Inc. Manila

Horngren, Charles T., Harrizon Jr., Walter T, & Bamber, Linda S. Accounting.
Fifth Edition. Prentice Hall International Edition

Medina, Roberto G. (2016 reprint) Business Finance. Rex Book Store, Manila.
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Supplementary Reading Materials

Lecture notes, The Capital Asset Pricing Model - Fine 441: Investment
https://www.studocu.com › Mcgill University › Investment Management
investment management chapter vii the capital asset pricing model capital
asset pricing model(capm) model of financial market equilibrium that allows
the.
Accessed: November 3, 2017

[PDF]Lecture 05: Mean-Variance Analysis & Capital Asset Pricing Model

https://www.princeton.edu/~markus/teaching/Eco525/05%20CAPM_a.pdf
Mean-Variance Analysis and CAPM. Eco 525: Financial Economics I. Slide 05-
1. Lecture 05: Mean-Variance Analysis &. Capital Asset Pricing Model.
(CAPM).
Accessed: November 3, 2017

Portfolio Diversification and Supporting Financial Institutions (CAPM ...

https://oyc.yale.edu/economics/econ-252-08/lecture-4
Lecture 4. - Portfolio Diversification and Supporting Financial Institutions
(CAPM Model). Overview. Portfolio diversification is the most fundamental
concept of ...
Accessed: November 3, 2017

Supplementary Online Videos

The CAPM and APT | Video Lectures and Slides | Finance Theory I ...
https://ocw.mit.edu/courses/sloan-school-of.../15...lectures.../the-capm-
and-apt/
This page includes lecture slides and three video lectures on the capital asset
pricing model and arbitrage pricing theory as means of performance
evaluation of ...
Accessed: November 3, 2017

Capital Asset Pricing Model - YouTube

https://www.youtube.com/watch?v=gZCYoh-6rhY

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Capital Asset Pricing Model and Modern Portfolio Theory

Nov 21, 2014 - Uploaded by WHU - Otto Beisheim School of Management

WHU - Otto Beisheim School of Management. ... Professor Dr. Markus Rudolf,
Allianz Endowed Chair of ...
Accessed: November 3, 2017