10-0

CHAPTER

10

The Capital Asset

Pricing Model (CAPM)

10-1

Expected Return, Standard Deviation, Variance,

Covariance and Correlation Coefficient
Expected Return: This is the return an investor expects
to earn on an asset given its price, growth potential etc.
Standard Deviation: Standard deviation is often used by
investors to measure the risk of a stock or a stock
portfolio. The basic idea is that the standard deviation is
the measure of volatility. The more a stocks return vary
from the stocks average (mean) return, the more volatile
is the stock. Standard deviation is the square root of
variance.
Variance: measures the squared deviations of a stocks
return from its average (mean) return.

10-2

Expected Return, Standard Deviation, Variance,

Covariance and Correlation Coefficient
Covariance: is a statistical measurement of
interrelationship between two variables (stocks,
bonds) etc.
Correlation Coefficient: A statistical measure of
degree of relationship between two variables.

10-3

Expected Return, Variance,

and Standard Deviation
Scenario Probability
Recession 33.33%
Normal
33.33%
Boom 33.33%

Rate of Return
Stock fund Bond fund
-7%
17%
12%
7%
28%
-3%

Consider the following two risky assets. There is

a 1/3 chance of each state of the economy and the
only assets are a stock fund and a bond fund.

10-4

Expected Return, Variance,

and Standard Deviation

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

Stock fund
Rate of
Squared
Return Deviation
-7%
3.24%
12%
0.01%
28%
2.89%
11.00%
0.0205
14.3%

Bond Fund
Rate of
Squared
Return Deviation
17%
1.00%
7%
0.00%
-3%
1.00%
7.00%
0.0067
8.2%

10-5

The Return and Risk

for Portfolios
Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

Stock fund
Rate of
Squared
Return Deviation
-7%
3.24%
12%
0.01%
28%
2.89%
11.00%
0.0205
14.3%

Bond Fund
Rate of
Squared
Return Deviation
17%
1.00%
7%
0.00%
-3%
1.00%
7.00%
0.0067
8.2%

Note that stocks have a higher expected return than bonds and
higher risk. Let us turn now to the risk-return tradeoff of a portfolio
that is 50% invested in bonds and 50% invested in stocks.

10-6

The Return and Risk for Portfolios

Rate of Return
Stock fund Bond fund Portfolio squared deviation
-7%
17%
5.0%
0.160%
12%
7%
9.5%
0.003%
28%
-3%
12.5%
0.123%

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

11.00%
0.0205
14.31%

7.00%
0.0067
8.16%

9.0%
0.0010
3.16%

The expected rate of return on the portfolio is a weighted average

of the expected returns on the securities in the portfolio.

E (rP ) = wB E (rB ) + wS E (rS )

9% = 50% ( 9 %) + 50% (11%)

10-7

The Return and Risk for Portfolios

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

Rate of Return
Stock fund Bond fund Portfolio squared deviation
-7%
17%
5.0%
0.160%
12%
7%
9.5%
0.003%
28%
-3%
12.5%
0.123%
11.00%
0.0205
14.31%

7.00%
0.0067
8.16%

9.0%
0.0010
3.16%

The variance of the rate of return on the two risky assets portfolio is
2
2
=
+

(wB B ) (wS S ) + 2(wB B )(wS S ) rBS

2
P

where rBS is the correlation coefficient between the returns on the

stock and bond funds.

10-8

The Return and Risk for Portfolios

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

Rate of Return
Stock fund Bond fund Portfolio squared deviation
-7%
17%
5.0%
0.160%
12%
7%
9.5%
0.003%
28%
-3%
12.5%
0.123%
11.00%
0.0205
14.31%

7.00%
0.0067
8.16%

9.0%
0.0010
3.16%

Observe the decrease in risk that diversification offers.

An equally weighted portfolio (50% in stocks and 50% in bonds)
has less risk than stocks or bonds held individually.

10-9

% in stocks

Risk

Return

0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50.00%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%

8.2%
7.0%
5.9%
4.8%
3.7%
2.6%
1.4%
0.4%
0.9%
2.0%
3.16%
4.2%
5.3%
6.4%
7.6%
8.7%
9.8%
10.9%
12.1%
13.2%
14.3%

7.0%
7.2%
7.4%
7.6%
7.8%
8.0%
8.2%
8.4%
8.6%
8.8%
9.00%
9.2%
9.4%
9.6%
9.8%
10.0%
10.2%
10.4%
10.6%
10.8%
11.0%

Portfolio Return

The Efficient Set for Two Assets

Portfolo Risk and Return Combinations
12.0%
11.0%

100%
stocks

10.0%
9.0%
8.0%
7.0%
6.0%

100%
bonds

5.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%

Portfolio Risk (standard deviation)

We can consider other

portfolio weights besides
50% in stocks and 50% in
bonds

10-10

% in stocks

Risk

Return

0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%

8.2%
7.0%
5.9%
4.8%
3.7%
2.6%
1.4%
0.4%
0.9%
2.0%
3.1%
4.2%
5.3%
6.4%
7.6%
8.7%
9.8%
10.9%
12.1%
13.2%
14.3%

7.0%
7.2%
7.4%
7.6%
7.8%
8.0%
8.2%
8.4%
8.6%
8.8%
9.0%
9.2%
9.4%
9.6%
9.8%
10.0%
10.2%
10.4%
10.6%
10.8%
11.0%

Portfolio Return

The Efficient Set for Two Assets

Portfolo Risk and Return Combinations
12.0%
11.0%
10.0%
9.0%
8.0%
7.0%
6.0%

100%
stocks
100%

5.0%
bonds
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%

Portfolio Risk (standard deviation)

Note that some portfolios are

better than others. They have
higher returns for the same level of
risk or less. These compromise the
efficient frontier.

10-11

return

Two-Security Portfolios with Various Correlations

100%
stocks

r = -1.0

100%
bonds

r = 1.0
r = 0.2

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

10-12

Portfolio Risk as a Function of the Number of Stocks

in the Portfolio

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
Thus diversification can eliminate some,
but not all of the risk of individual securities.

10-13

return

The Efficient Set for Many Securities

Individual Assets

Consider a world with many risky assets; we can still

identify the opportunity set of risk-return combinations
of various portfolios.

10-14

return

The Efficient Set for Many Securities

minimum
variance
portfolio
Individual Assets

Given the opportunity set we can identify the

minimum variance portfolio.

10-15

return

The Efficient Set for Many Securities

minimum
variance
portfolio
Individual Assets

The section of the opportunity set above the minimum

variance portfolio is the efficient frontier.

10-16

return

Optimal Risky Portfolio with a Risk-Free Asset

100%
stocks

rf
100%
bonds

In addition to stocks and bonds, consider a world

that also has risk-free securities like T-bills

10-17

return

Riskless Borrowing and Lending

100%
stocks
Balanced
fund

rf
100%
bonds

Now investors can allocate their money across the

T-bills and a balanced mutual fund

10-18

return

Riskless Borrowing and Lending

rf

With a risk-free asset available and the efficient frontier

identified, we choose the capital market line with the
steepest slope

10-19

return

The Separation Property

100%
stocks
Optimal
Risky
Portfolio

rf
100%
bonds

The separation property implies that portfolio choice can be

separated into two tasks: (1) determine the optimal risky portfolio,
and (2) selecting a point on the CML.

10-20

return

Market Equilibrium

M
rf

P
With the capital market 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.

10-21

return

Market Equilibrium
100%
stocks
Balanced
fund

rf
100%
bonds

Just where the investor chooses along the Capital Market Line
depends on his risk tolerance. The big point though is that all
investors have the same CML.

10-22

return

Optimal Risky Portfolio with a Risk-Free Asset

1
f
0
f

r
r

100%
stocks
First
Optimal
Risky
Portfolio

Second Optimal
Risky Portfolio

100%
bonds

By the way, the optimal risky portfolio depends on

the risk-free rate as well as the risky assets.

10-23

Definition of Risk When Investors Hold

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.

bi =

Cov ( Ri , RM )

( RM )
2

10-24

Relationship between Risk

and Expected Return (CAPM)

Expected Return on the Market:

R M = RF + Market Risk Premium

Expected return on an individual security:

Ri = RF + i ( R M RF )
Market Risk Premium

This applies to individual securities held within welldiversified portfolios.

10-25

Expected Return on an Individual Security

This formula is called the Capital Asset Pricing
Model (CAPM)
Ri = RF + i ( RM RF )
Expected
return on
a security

RiskBeta of the
+

free rate
security

Market risk
premium

Assume bi = 0, then the expected return is RF.

Assume bi = 1, then Ri = RM

10-26

Expected return

Relationship Between Risk & Expected Return

Ri = RF + i ( RM RF )
RM
RF
1.0

10-27

Expected
return

Relationship Between Risk & Expected Return

13.5%
3%

i = 1.5

RF = 3%

1.5

RM =10%
R i = 3% + 1.5 (10% 3%) = 13.5%

10-28

End of the Chapter