CAPM Application

Example 1: You are considering an investment in the Alaskan crab fishing

industry. Crab fishing is known to be a very risky business. The injury
rate and death toll in the industry are both very high. Also, crab fishing
firms have very volatile earnings. This is because their cash flows come
from the catch, which is mainly determined by unpredictable local
weather condition. Assume that the risk-free rate is 2%, and the market
risk premium is 5%. Determine a proper discount rate for this investment.
Ans:
Although the fishing industry is subject to high idiosyncratic risk, its
systematic risk is almost zero.
Thus, its beta is zero
E(r) = rf + β[E(rm)-rf] = 2% + 0 = 2%
Zero beta does not mean zero risk

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Example 1 (Cont’d)
• Does anyone really want to buy this kind of stock?
• Ans: Yes, because it is a good hedging choice. Including
this stock reduces my overall portfolio risk.
• Do I still want to hold this stock when there is a risk-free
asset?
– Yes, because the risk-free asset does not change the shape of the
hyperbola.
• What happens if you accidentally include the risk-free
asset when constructing the portfolio frontier?
– You get a strait line as you portfolio frontier.
– This strait line is the CAL with the risk-free asset and the three
risky assets (LRGSTK, MEDSTK, and SMLSTK)

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Example 1 (Cont’d)

0.010
No Fishing
With Fishing
0.008
Excess Return

0.006
0.004
0.002

0.00 0.02 0.04 0.06 0.08 0.10

S.D.

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Example 1 (Cont’d)

0.010
No T-bill
With T-bill
0.008
Excess Return

0.006
0.004
0.002

0.00 0.02 0.04 0.06 0.08 0.10

S.D.

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Example 1 (Cont’d)
• The fishing company expand the hyperbola. The risk-free
asset does not.
• Q: How can a risky asset with low beta serve the risk
reduction function that the risk-free asset fails to achieve?

Ans:
• It is possible that the fishing company has high excess
return when the market is bad.
• This feature helps cancel out losses from other assets.
• The risk-free asset does not serve this function.
– Its excess is always zero by definition.

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