CAPM and the Characteristic

Line
The Characteristic Line

 Total risk of any asset can be assessed by

measuring variability of its returns
 Total risk can be divided into two parts—
diversifiable risk (unsystematic risk) and non-
diversifiable risk (systematic risk)
 The characteristic line is used to measure
statistically the undiversifiable risk and
diversifiable risk of individual assets and
portfolios
Characteristic line for the ith asset is:
ri,t = ai + birm,t + ei,t OR

ri,t = birm,t + ai + ei,t

Take Variance of both sides of Equation

 VAR (ri,t) = VAR(birm,t ) +VAR(ai) + VAR(ei,t)
 VAR(birm,t ) = VAR (ri,t) - VAR(ei,t) OR
 VAR(ei,t) = VAR(ri,t) - VAR(birm,t )
 Beta Coefficients

An index of risk

Measures the volatility of a stock (or

portfolio) relative to the market
 Beta Coefficients Combine
The variability of the asset’s return

The variability of the market return

The correlation between

– the stock's return and
– the market return
Beta Coefficients

Beta coefficients are the slope of

the regression line relating
– the return on the market (the
independent variable) to
– the return on the stock (the
dependent variable)
Beta Coefficients
Interpretation of the
Numerical Value of Beta

Beta = 1.0 Stock's return has

same volatility as the market return

Beta > 1.0 Stock's return is more

volatile than the market return
Interpretation of the
Numerical Value of Beta
Interpretation of the Numerical
Value of Beta
Beta < 1.0 Stock's return is less
volatile than the market return
Interpretation of the Numerical
Value of Beta
High Beta Stocks

More systematic market risk

May be appropriate for high-risk

tolerant (aggressive) investors
Low Beta Stocks

Less systematic market risk

May be appropriate for low-risk

tolerant (defensive) investors
Individual Stock Betas

May change over time

Tendency to move toward 1.0, the

market beta
Portfolio Betas

Weighted average of the individual

asset's betas

May be more stable than

individual stock betas
How Characteristic Line leads
to CAPM?
The characteristic regression line of an
asset explains the asset’s systematic
variability of returns in terms of market
forces that affect all assets simultaneously
The portion of total risk not explained by
characteristic line is called unsystematic
risk
Assets with high degrees systematic
risk must be priced to yield high
returns in order to induce investors to
accept high degrees of risk that are
undivesifiable in the market
CAPM illustrates positive relationship
between systematic risk and return on
an asset
Capital Asset Pricing Model
(CAPM)
For a very well-diversified portfolio, beta
is the correct measure of a security’s risk.
All investments and portfolios of
investments must lie along a straight-line
in the return-beta space
Required return on any asset is a linear
function of the systematic risk of that asset
E(ri) = rf + [E(rm) – rf]  i
The Capital Asset Pricing
Model (CAPM)

The CAPM has

– A macro component explains risk
and return in a portfolio context
– A micro component explains
individual stock returns
– The micro component is also used
to value stocks
Beta Coefficients and
The Security Market Line

The return on a stock depends on

– the risk free rate (rf)
– the return on the market (rm)
– the stock's beta
– the return on a stock:
k= rf + (rm - rf)beta
Beta Coefficients and
The Security Market Line

The figure relating systematic risk

(beta) and the return on a stock
Beta Coefficients and
The Security Market Line
CAPM can be used to price any asset provided
we know the systematic risk of that asset
In equilibrium, every asset must be priced so
that its risk-adjusted required rate of return
falls exactly on the straight line
If an investment were to lie above or below
that straight line, then an opportunity for
riskless arbitrage would exist.
Examples of CAPM

Stocks Expected Return Beta

A 16% 1.2
B 19% 1.3
C 13% 0.75
E(rm) = 18% rf = 14%
Which of these stocks is correctly priced?
Example of CAPM

Given the following security market line

E(ri) = 0.07 + 0.09I

What must be the returns for two stocks

assuming their betas are 1.2 and 0.9?