Asset Pricing Principles
Chapter 9
Charles P. Jones, Investments: Principles and Concepts,
Twelfth Edition, John Wiley & Sons
91
Positive rather than normative
Describes how investors could behave not how
they should be have
Focus on the equilibrium relationship
between the risk and expected return on
risky assets
Builds on Markowitz portfolio theory
Each investor is assumed to diversify his or
her portfolio according to the Markowitz
model
92
Assumes all
investors:
Use the same
information to
generate an efficient
frontier
Have the same oneperiod time horizon
Can borrow or lend
money at the risk-free
rate of return
No transaction costs,
no personal income
taxes, no inflation
No single investor
can affect the price
of a stock
Capital markets are
in equilibrium
93
Risk-Free Assets, Borrowing,
Lending
Risk free assets
No correlation with risky assets
Usually proxied by a Treasury security
Adding a risk-free asset extends and
changes the efficient frontier
Lending because investor lends money to
issuer
With borrowing, investor no longer
restricted to own wealth
94
Riskless assets can
be combined with
L
any portfolio in the
B
efficient set AB
E(R)
Z implies lending
T
Z
RF
A
Set of portfolios on
line RF to T
dominates all
portfolios below it
Risk
9-5
Risk-free investing and borrowing creates a
new set of expected return-risk possibilities
Addition of risk-free asset results in
A change in the efficient set from an arc to a
straight line tangent to the feasible set without
the riskless asset
Chosen portfolio depends on investors risk-return
preferences
96
L
M
E(RM)
x
RF
M
Risk
Line from RF to L is
capital market line
(CML)
x = risk premium
=E(RM) - RF
y =risk =M
Slope =x/y
=[E(RM) - RF]/M
y-intercept = RF
9-7
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(RM ) RF
E(Rp ) RF
p
M
98
Most important implication of the CAPM
The portfolio of all risky assets is the optimal risky
portfolio (called the market portfolio)
The expected price of risk is always positive
The optimal portfolio is at the highest point of
tangency between RF and the efficient frontier
All investors hold the same optimal portfolio of
risky assets
99
All risky assets must be in portfolio, so it is
completely diversified
Includes only systematic risk
Unobservable but approximated with
portfolio of all common stocks
In turn approximated with S&P 500
All securities included in proportion to their
market value
910
Investors use their preferences (reflected in
an indifference curve) to determine optimal
portfolio
Separation Theorem
The investment decision about which risky portfolio
to hold is separate from the financing decision
Investment decision does not involve investor
Financing decision depends on investors preferences
911
CML Equation only applies to markets in
equilibrium and efficient portfolios
The Security Market Line depicts tradeoff
between risk and expected return for
individual securities
Under CAPM, all investors hold the market
portfolio
Relevant risk of any security is therefore its
covariance with the market portfolio
912
Beta
Standardized measure of systematic risk
Relative measure of risk: risk of an
individual stock relative to the market
portfolio of all stocks
Relates covariance of an asset with the
market portfolio to the variance of the
Covi, M
market portfolio
913
Beta
SM
L
E(R)
kM
kRF
Beta = 1.0 implies
as risky as market
Securities A and B
are more risky than
the market
Beta >1.0
Security C is less
risky than the
0.5 1.0 1.5 2.0 market
BetaM
Beta <1.0
9-14
Required rate of return on an asset (ki) is
composed of
risk-free rate (RF)
risk premium (i [ E(RM) - RF ])
Market risk premium adjusted for specific security
ki = RF +i [ E(RM) - RF ]
The greater the systematic risk, the greater the
required return
915
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
916
Market model
Relates the return on each stock to the return on
the market, assuming a linear relationship
Produces an estimate of return for any stock
Ri = i + i RM +ei
Characteristic line
Line fit to total returns for a security relative to
total returns for the market index
917
Betas change with a companys situation
Estimating a future beta
May differ from the historical beta
RM represents the total of all marketable
assets in the economy
Approximated with a stock market index
Approximates return on all common stocks
918
No one correct number of observations and
time periods for calculating beta
Therefore, estimates of beta vary
The regression calculations of the true
and from the characteristic line are
subject to estimation error
Portfolio betas more reliable than individual
security betas
919
Tests of CAPM
Assumptions are mostly unrealistic
Empirical evidence has not led to consensus
However, some points are widely agreed
upon
SML appears to be linear
Intercept is generally higher than RF
Slope of the CAPM is generally less than theory
predicts
Its likely that only systematic risk is rewarded
920
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
921
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 non-zero prices
Risk factors must be unpredictable to the market
922
Most important are the deviations of the
factors from their expected values
Expected return is directly related to sensitivity
CAPM assumes risk is only sensitivity to market
The expected return-risk relationship for the
APT can be described as:
E(Ri) =RF +bi1 (risk premium for factor 1)
+bi2 (risk premium for factor 2) +
+bin (risk premium for factor n)
923
Factors are not well specified ex ante
To implement the APT model, need the factors
that account for the differences among security
returns
CAPM identifies market portfolio as single factor
Studies suggest certain factors are reflected
in market
Focus on cash flows and discount rate
Both CAPM and APT rely on unobservable
expectations
924
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925
