AN INTRODUCTION TO ASSET
PRICING MODELS
1
ASSUMPTIONS OF CAPITAL MARKET
THEORY
Investors are Markowitz-efficient
Borrow or lend any amount of money at the risk-free rate
Homogeneous expectations
Same one-period time horizon
All investments are infinitely divisible
No taxes or transaction costs
No inflation or any change in interest rates
Capital markets are in equilibrium
2
DEVELOPMENT OF CAPITAL MARKET
THEORY
Concept of a risk-free asset
Zero variance
Zero correlation
William Sharpe (1964),
Lintner (1965)
Mossin (1966)
3
DEVELOPING CAPITAL MARKET LINE
Covariance with a Risk-Free Asset
Combining a Risk-Free Asset with a Risky Portfolio
Expected Return
Standard Deviation
The Risk-Return Combination
4
THE CAPITAL MARKET LINE
5
THE CAPITAL MARKET LINE
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RISK, DIVERSIFICATION, AND THE
MARKET PORTFOLIO
Unsystematic or unique risk
Systematic risk
How to Measure Diversification?
Lorie (1975) - Completely diversified portfolio would have a
correlation with the market portfolio of +1.00
7
DIVERSIFICATION AND THE
ELIMINATION OF UNSYSTEMATIC
RISK
8
THE CML AND THE SEPARATION
THEOREM
Position on the CML depends on investors risk
preferences
Risk averse
Risk taker
Tobin (1958) called this division of the investment
decision from the financing decision the separation
theorem.
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A RISK MEASURE FOR THE CML
Asset’s covariance with the market portfolio
Rates of return in relation to the returns to Portfolio M
Variance of returns for a risky asset
10
INVESTING WITH THE CML: AN
EXAMPLE
11
INVESTING WITH THE CML: AN
EXAMPLE
Select the optimal portfolio for investment. Assume
RFR=4%.
Suppose now that given your risk tolerance you are
willing to assume a standard deviation of 8.5 percent.
How should you go about investing your money,
according to the CML?
Consider what would happen if you were willing to take
on a risk level of σ = 15 percent.
12
THE CAPITAL ASSET PRICING MODEL
CML expressed the risk-return trade-off for fully
diversified portfolios as follows:
E RM RFR
E Ri RFR i
M
CAPM
13
THE SECURITY MARKET LINE
14
DETERMINING THE EXPECTED RATE
OF RETURN FOR A RISKY ASSET
Consider the following example stocks, assuming you
have already computed betas:
Assume that we expect the economy’s RFR to be 5
percent (0.05) and the expected return on the market
portfolio (E(RM)) to be 9 percent (0.09). With these
inputs, compute required rates of return for these five
stocks: 15
IDENTIFYING UNDERVALUED AND
OVERVALUED ASSETS
Assume that analysts at a major brokerage firm have
been following the five stocks in the preceding example.
Based on extensive fundamental analysis, they provide
you with forecasted price and dividend information for
the next year.
16
IDENTIFYING UNDERVALUED AND
OVERVALUED ASSETS
17
CALCULATING SYSTEMATIC RISK
i Cov Ri , RM
i riM
M 2
M
18
ESTIMATION ISSUES
The Impact of the Time Interval
Use of monthly versus weekly return intervals
The Effect of the Market Proxy
S&P 500 (SPX), an index of stocks mostly domiciled in the
United States
The MSCI World Equity (MXWO) index, which represents a
global portfolio of stocks.
19
CALCULATE BETA, INTERCEPT AND
CORR. COEFFICIENT?
20
21
RELAXING THE ASSUMPTIONS
Differential Borrowing and Lending Rates
Zero-Beta Model
Transaction Costs
Heterogeneous Expectations and Planning Periods
Taxes
22
DIFFERENTIAL BORROWING AND
LENDING RATES
23
ZERO-BETA MODEL
24
TRANSACTION COSTS
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HETEROGENEOUS EXPECTATIONS
AND PLANNING PERIODS
Unique CML or SML
Composite graph would be a group of lines with a
breadth determined by the divergence of expectations
If all investors had similar information and background,
the width of the group would be reasonably narrow.
26
TAXES
The expected returns in the CAPM are pretax returns. In
fact, the actual returns for most investors are affected as
follows:
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ADDITIONAL EMPIRICAL TESTS OF
THE CAPM
Stability of Beta
Relationship between Systematic Risk and Return
Effect of Skewness on the Relationship
Effect of Size, P/E, and Leverage
Effect of Book-to-Market Value
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THE MARKET PORTFOLIO: THEORY
VERSUS PRACTICE
Market portfolio included all the risky assets in the
economy
Although this concept is reasonable in theory, it is
difficult to implement when testing or using the CAPM.
Proxy for the market portfolio - benchmark error
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THE MARKET PORTFOLIO: THEORY
VERSUS PRACTICE
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THE MARKET PORTFOLIO: THEORY
VERSUS PRACTICE
31
THE MARKET PORTFOLIO: THEORY
VERSUS PRACTICE
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