Capital Market Line

 Line from RF to L is
L capital market line (CML)
 x = risk premium
M
E(RM) = E(RM) - RF
 y = risk = σ M
x
 Slope = x/y
RF = [E(RM) - RF]/σ
y M

 y-intercept = RF

σ M
Risk
 Capital Market Line

Slope of the CML is the market price of risk for

efficient portfolios, or the equilibrium price of risk
in the market
Relationship between risk and expected return for
portfolio P (Equation for CML):

E(R M ) − RF
E(R p ) = RF + σp
σM
 Security Market Line

CML Equation only applies to markets in

equilibrium and efficient portfolios
The Security Market Line depicts the tradeoff
between risk and expected return for individual
securities
Under CAPM, all investors hold the market
portfolio
 How does an individual security contribute to the risk of
the market portfolio?
 Security Market Line

Equation for expected return for an individual

stock similar to CML Equation

E(R M ) − RF σ i,M
E(R i ) = RF +
σM σM
= RF + β i [ E(R M ) − RF]
 Security Market Line

 Beta = 1.0 implies as

SM risky as market
L  Securities A and B are
E(R)
more risky than the
A market
E(RM) B  Beta > 1.0
C  Security C is less risky
RF
than the market
 Beta < 1.0

0 0.5 1.0 1.5 2.0

BetaM
 Security Market Line

Beta measures systematic risk

 Measures relative risk compared to the market portfolio of
all stocks
 Volatility different than market
All securities should lie on the SML
 The expected return on the security should be only that
return needed to compensate for systematic risk
 SML and Asset Values
Er
Underpriced SML: Er = rf + β (Erm – rf)

Overpriced

rf
β

Underpriced ⇒ expected return > required return according to CAPM

⇒ lie “above” SML
Overpriced ⇒ expected return < required return according to CAPM
⇒ lie “below” SML
Correctly priced ⇒ expected return = required return according to CAPM
⇒ lie along SML
 CAPM’s Expected Return-Beta
Relationship

Required rate of return on an asset (ki) is

composed of
 risk-free rate (RF)
 risk premium (β i [ E(RM) - RF ])
 Market risk premium adjusted for specific security
ki = RF +β i [ E(RM) - RF ]
 The greater the systematic risk, the greater the required
return
 Estimating the SML

Treasury Bill rate used to estimate RF

Expected market return unobservable
 Estimated using past market returns and taking an expected
value
Estimating individual security betas difficult
 Only company-specific factor in CAPM
 Requires asset-specific forecast
 Estimating Beta

Market model
 Relates the return on each stock to the return on the
market, assuming a linear relationship
Rit =α i +β i RMt + eit
 Test of CAPM

Empirical SML is “flatter” than predicted SML

Fama and French (1992)
 Market
 Size
 Book-to-market ratio
Roll’s Critique
 True market portfolio is unobservable
 Tests of CAPM are merely tests of the mean-variance
efficiency of the chosen market proxy
 Arbitrage Pricing Theory

Based on the Law of One Price

 Two otherwise identical assets cannot sell at different
prices
 Equilibrium prices adjust to eliminate all arbitrage
opportunities
Unlike CAPM, APT does not assume
 single-period investment horizon, absence of personal
taxes, riskless borrowing or lending, mean-variance
decisions
 Factors

APT assumes returns generated by a factor model

Factor Characteristics
 Each risk must have a pervasive influence on stock returns
 Risk factors must influence expected return and have
nonzero prices
 Risk factors must be unpredictable to the market
 APT Model

Most important are the deviations of the factors

from their expected values
The expected return-risk relationship for the
APT can be described as:
E(Rit) =a0+bi1 (risk premium for factor 1) +bi2 (risk
premium for factor 2) +… +bin (risk premium
for factor n)
 APT Model

Reduces to CAPM if there is only one factor and

that factor is market risk
Roll and Ross (1980) Factors:
 Changes in expected inflation
 Unanticipated changes in inflation
 Unanticipated changes in industrial production
 Unanticipated changes in the default risk premium
 Unanticipated changes in the term structure of interest
rates
 Problems with APT

Factors are not well specified ex ante

 To implement the APT model, the factors that account
for the differences among security returns are required
 CAPM identifies market portfolio as single factor
Neither CAPM or APT has been proven superior
 Both rely on unobservable expectations
 Two-Security Case

For a two-security portfolio containing Stock A and

Stock B, the variance is:

σ = x σ + x σ + 2 xA xB ρ ABσ Aσ B
2
p
2
A
2
A
2
B
2
B

17
 Two Security Case (cont’d)

Example

Assume the following statistics for Stock A and Stock B:

Stock A Stock B
Expected return .015 .020
Variance .050 .060
Standard deviation .224 .245
Weight 40% 60%
Correlation coefficient .50
18
 Two Security Case (cont’d)
19

Example (cont’d)

What is the expected return and variance of this two-security

portfolio?
 Two Security Case (cont’d)
20

Example (cont’d)

Solution: The expected return of this two-security portfolio is:

n
E ( R%
p ) = ∑  x
 i
i =1
E ( %) 
Ri 

=  x A E ( R%)
A 
 +  x
 B E ( %) 
RB 

= [ 0.4(0.015)] + [ 0.6(0.020) ]
= 0.018 = 1.80%
 Two Security Case (cont’d)
21

Example (cont’d)

Solution (cont’d): The variance of this two-security portfolio is:

σ 2p = x A2σ A2 + xB2 σ B2 + 2 xA xB ρ ABσ Aσ B

= (.4) (.05) + (.6) (.06) + 2(.4)(.6)(.5)(.224)(.245)
2 2

= .0080 + .0216 + .0132

= .0428
 Minimum Variance Portfolio
22

The minimum variance portfolio is the particular

combination of securities that will result in the least
possible variance

Solving for the minimum variance portfolio requires

basic calculus
 Minimum Variance
Portfolio (cont’d)
23

For a two-security minimum variance portfolio, the

proportions invested in stocks A and B are:

σ − σ Aσ B ρ AB
2
xA = 2 B
σ A + σ B − 2σ Aσ B ρ AB
2

xB = 1 − x A
 Minimum Variance
Portfolio (cont’d)
24

Example (cont’d)

Assume the same statistics for Stocks A and B as in the previous example.
What are the weights of the minimum variance portfolio in this case?
 Minimum Variance
Portfolio (cont’d)
25

Example (cont’d)

Solution: The weights of the minimum variance portfolios in this case

are:

σ B2 − σ Aσ B ρ AB .06 − (.224)(.245)(.5)
xA = 2 = = 59.07%
σ A + σ B − 2σ Aσ B ρ AB .05 + .06 − 2(.224)(.245)(.5)
2

xB = 1 − x A = 1 − .5907 = 40.93%
 Minimum Variance
Portfolio (cont’d)
26

Example (cont’d)

1.2

0.8

0.6
At hgi e W

0.4

0.2

0
0 0.01 0.02 0.03 0.04 0.05 0.06
Portfolio Variance
 Correlation and
Risk Reduction
27

Portfolio risk decreases as the correlation coefficient

in the returns of two securities decreases
Risk reduction is greatest when the securities are
perfectly negatively correlated
If the securities are perfectly positively correlated,
there is no risk reduction
 The n-Security Case
28

For an n-security portfolio, the variance is:

n n
σ = ∑∑ xi x j ρijσ iσ j
2
p
i =1 j =1

where xi = proportion of total investment in Security i

ρij = correlation coefficient between
Security i and Security j
 The n-Security Case (cont’d)
29

A covariance matrix is a tabular presentation of

the pairwise combinations of all portfolio
components
 The required number of covariances to compute a portfolio
variance is (n2 – n)/2

 Any portfolio construction technique using the full covariance

matrix is called a Markowitz model
 Computational Advantages
30

The single-index model compares all securities to

a single benchmark
 An alternative to comparing a security to each of the others

 By observing how two independent securities behave relative

to a third value, we learn something about how the securities
are likely to behave relative to each other
 Computational
Advantages (cont’d)
31

A single index drastically reduces the number of

computations needed to determine portfolio variance
 A security’s beta is an example:

COV ( R% %
i , Rm )
βi =
σ m2
where R% = return on the market index
m

σ m2 = variance of the market returns

R% i = return on Security i
 Portfolio Statistics With the Single-Index
Model
32

Beta of a portfolio:

n
β = ∑ xi βi
Variance of a portfolio:
p
i =1

σ 2p = β p2σ m2 + σ ep2
≈ β p2σ m2
 Portfolio Statistics With the Single-Index
Model (cont’d)
33

Variance of a portfolio component:

σ = β σ +σ
i
2
i
2 2
m
2
ei
Covariance of two portfolio components:

σ AB = β A β Bσ 2
m