CAPM
Assumptions
Individuals are risk averse
Maximize utility over a single period time
horizon
Homogeneous expectations
Borrow and lend freely at same rate
Perfect market
Requirement of CAPM
Leveraged portfolio: Borrowing and
investing
Unleveraged portfolio : riskless investment
KEY ISSUES
Essentially, the capital asset pricing model (CAPM) is
concerned with two questions:
• What is the relationship between risk and return for an
efficient portfolio?
• What is the relationship between risk and return for an
individual security?
CAPITAL MARKET LINE
EXPECTED
RETURN, E(Rp) Z
•
L
M •
• K
Rf
STANDARD DEVIATION, p
Lending and borrowing
Lending: Investment in risk free asset
Borrowing : Increase in total fund invested
through trading on equity
If X is the % of fund invested in risky asset
X=1 Total equity investment
X<1 only fraction in risky asset
X> 1 risky asset is more than riskless asset
SECURITY MARKET LINE
E(RM) - Rf
E(Ri ) = Rf + CiM
M
iM
βi =
M
E (R i ) = R f + [ E (R M) - R f ] β i
EXPECTED •P
RETURN SML
14%
8% •0
ALPHA = EXPECTED - FAIR
RETURN RETURN
RELATIONSHIP BETWEEN SML AND CML
SML
E(RM ) - Rf
E(Ri) = Rf + σiM
σM 2
SINCE σiM = iM σi σM
E(RM ) - Rf
E(Ri) = Rf + iM σi
σM
IF i AND M ARE PERFECTLY CORRELATED iM = 1. SO
E(RM ) - Rf
E(Ri) = Rf + σi
σM
INPUTS REQUIRED FOR
APPLYING CAPM
RISK-FREE RETURN
• RATE ON A SHORT-TERM GOVT SECURITY
• RATE ON A LONG TERM GOVT BOND
MARKET RISK PREMIUM
• HISTORICAL
• DIFFERENCE BETWEEN THE AVERAGE RETURN ON
STOCKS AND THE AVERAGE RISK - FREE RETURN
PERIOD : AS LONG AS POSSIBLE
AVERAGE : A.M VS. G.M.
DETERMINANTS OF RISK PREMIUM
• VARIANCE IN THE UNDERLYING ECONOMY
• POLITICAL RISK
• MARKET STRUCTURE
FINANCIAL MARKET EXAMPLES PREMIUM OVER THE
CHARACTERISTICS GOVT BOND RATE (%)
EMERGING MARKET, WITH SOUTH AMERICAN MARKETS, 7.5 - 9.5
POLITICAL RISK CHINA, RUSSIA
EMERGING MARKETS WITH SINGAPORE, MALAYSIA, 7.5
LIMITED POLITICAL RISK THAILAND, INDIA, SOME EAST
EUROPEAN MARKETS
DEVELOPED MARKETS WITH UNITED STATES, JAPAN, U.K., 5.5
WIDE STOCK LISTINGS FRANCE, ITALY
DEVELOPED MARKETS WITH GERMANY, SWITZERLAND 3.5 - 4.5
LIMITED LISTINGS AND
STABLE ECONOMIES
* Source : Aswath Damodaran Corporate Finance Theory and Practice, John Wiley.
TRIUMPH OF OPTIMISTS
ELROY DIMSON, PAUL MARCH, AND MICHAEL
STANTON … TRIUMPH OF THE OPTIMISTS, (2001)
• EQUITY RETURNS … 16 RICH COUNTRIES …
DATA … 1900
• GLOBAL HISTORICAL RISK PREMIUM … 20TH
CENTURY .. 4.6%
• BEST ESTIMATE OF EQUITY PREMIUM
WORLDWIDE IN FUTURE IS 4 TO 5 PERCENT
CALCULATION OF BETA
Rit = i + i RMt + eit
iM
i =
M 2
CALCULATION OF BETA
Square of the
Return on Deviation of Deviation of Product of the
Return on deviation of
Period market return on stock A return on market deviation,
stock A, RA return on market
portfolio, RM from its mean portfolio from its (RA - RA)
portfolio from its
(RA - RA) mean (RM - RM) (RM - RM)
mean
(RM - RM)2
1 10 12 0 3 0 9
2 15 14 5 5 25 25
3 18 13 8 4 32 16
4 14 10 4 1 4 1
5 16 9 6 0 0 0
6 16 13 6 4 24 16
7 18 14 8 5 40 25
8 4 7 -6 -2 12 4
9 -9 1 -19 -8 152 64
10 14 12 4 3 12 9
11 15 -11 5 -20 -100 400
12 14 16 4 7 28 49
13 6 8 -4 -1 4 1
14 7 7 -3 -2 6 4
15 -8 10 -18 1 -18 1
RA = 150 RM = 135 (RA - RA) (RM - RM) 2
RA =10 RM = 9 (RM - RM) = 221 = 624
ESTIMATION ISSUES
• ESTIMATION PERIOD
• A LONGER ESTIMATION PERIOD PROVIDES MORE
DATA BUT THE RISK PROFILE .. FIRM MAY CHANGE
• 5 YEARS
• RETURN INTERVAL
DAILY, WEEKLY, MONTHLY
• MARKET INDEX
STANDARD PRACTICE
ADJUSTING HISTORICAL BETA
• HISTORICAL ALIGNMENT … CHANCE FACTOR
• A COMPANY’S BETA MAY CHANGE OVER TIME
MERILL LYNCH … 0.66 … HISTORICAL BETA
O.34 … MARKET BETA
BETAS BASED ON
FUNDAMENTAL INFORMATION
KEY FACTORS EMPLOYED ARE
• INDUSTRY AFFILIATION
• CORPORATE GROWTH
• EARNINGS VARIABILITY
• FINANCIAL LEVERAGE
• SIZE
BETAS BASED ON
ACCOUNTING EARNINGS
REGRESS THE CHANGES IN COMPANY EARNINGS
(ON A QUARTERLY OR ANNUAL BASIS) AGAINST
CHANGES IN THE AGGREGATE EARNINGS OF ALL
THE COMPANIES INCLUDED IN A MARKET INDEX.
LIMITATIONS
• ACCOUNTING EARNINGS .. GENERALLY SMOOTHED
OUT .. RELATIVE .. VALUE OF THE COMPANY
• ACCOUNTING EARNINGS … INFLUENCED BY NON -
OPERATING FACTORS
BETAS FROM CROSS
SECTIONAL REGRESSIONS
1. ESTIMATE A CROSS - SECTIONAL REGRESSION
RELATIONSHIP FOR PUBLICLY TRADED FIRMS:
BETA = 0.6507 + 0.27 COEFFICIENT OF VARIATION
IN OPERATING INCOME + 0.09 D/E + 0.54
EARNINGS - .00009 TOTAL ASSETS
(MILLION $)
2. PLUG THE CHARACTERISTICS OF THE PROJECT,
DIVISION, OR UNLISTED COMPANY IN THE
REGR’N REL’N TO ARRIVE AT AN ESTIMATE OF
BETA
BETA = 0.6507 + 0.27 (1.85) + 0.09 (0.90) + 0.54 (0.12) -
EMPIRICAL EVIDENCE
ON CAPM
1. SET UP THE SAMPLE DATA
Rit , RMt , Rft
2. ESTIMATE THE SECURITY CHARACTER-
-ISTIC LINES
Rit - Rft = ai + bi (RMt - Rft) + eit
3. ESTIMATE THE SECURITY MARKET LINE
Ri = 0 + 1 bi + ei , i = 1, … 75
EVIDENCE
IF CAPM HOLDS
• THE RELATION … LINEAR .. TERMS LIKE bi2 .. NO
EXPLANATORY POWER
• 0 ≃ Rf
• 1 ≃ RM - Rf
• NO OTHER FACTORS, SUCH AS COMPANY SIZE
OR TOTAL VARIANCE, SHOULD AFFECT Ri
• THE MODEL SHOULD EXPLAIN A SIGNIFICANT
PORTION OF VARIATION IN RETURNS AMONG
SECURITIES
GENERAL FINDINGS
• THE RELATION … APPEARS .. LINEAR
• 0 > Rf
• 1 < RM - Rf
• IN ADDITION TO BETA, SOME OTHER FACTORS,
SUCH AS STANDARD DEVIATION OF RETURNS
AND COMPANY SIZE, TOO HAVE A BEARING ON
RETURN
• BETA DOES NOT EXPLAIN A VERY HIGH
PERCENTAGE OF THE VARIANCE IN RETURN
CONCLUSIONS
PROBLEMS
• STUDIES USE HISTORICAL RETURNS AS PROXIES
FOR EXPECTATIONS
• STUDIES USE A MARKET INDEX AS A PROXY
POPULARITY
• SOME OBJECTIVE ESTIMATE OF RISK PREMIUM
.. BETTER THAN A COMPLETELY SUBJECTIVE
ESTIMATE
• BASIC MESSAGE .. ACCEPTED BY ALL
• NO CONSENSUS ON ALTERNATIVE
ARBITRAGE - PRICING THEORY
RETURN GENERATING PROCESS
Ri = ai + bi 1 I1 + bi2 I2 …+ bij I1 + ei
EQUILIBRIUM RISK - RETURN
RELATIONSHIP
E(Ri) = 0 + bi1 1 + bi2 2 + … bij j
j = RISK PREMIUM FOR THE TYPE OF
RISK ASSOCIATED WITH FACTOR j
SUMMING UP
• The relationship between risk and expected return for efficient portfolios, as given by the
capital market line, is:
E (Ri) = Rf + i
• The relationship between risk and expected return for an inefficient portfolio or a single
security as given by the security market line is :
iM
E (Ri) = Rf + E (RM) – Rf x M2
• The beta of a security is the slope of the following regression relationship:
Rit = i + i RMt + eit
• The commonly followed procedure for testing CAPM involves two steps. In the first step,
the security betas are estimated. In the second step, the relationship between security
beta and return is examined.
• Empirical evidence is favour of CAPM is mixed. Notwithstanding this, the CAPM is the
most widely used risk-return model because it is simple and intuitively appealing and its
basic message that diversifiable risk does not matter is generally accepted.
• The APT is much more general in that asset prices can be influenced by factors beyond
means and variances. The APT assumes that the return on any security is linearly related
to a set of systematic factors.
