Capital Asset Pricing Theory

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Chapter 13

• Capital Asset Pricing Theory

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Capital Asset Pricing Model (CAPM)
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CAPITAL ASSET PRICING MODELBasic Assumptions

• Investors hold efficient portfolios higher
  expected returns involve higher risk.
• Unlimited borrowing and lending are available at
  the risk-free rate.
• Investors have homogeneous expectations.
• There is a one-period time horizon.
• Investments are infinitely divisible.
• No taxes or transaction costs exist.
• Inflation is fully anticipated.
• Capital markets are in equilibrium.

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CAPM Market Efficiency

• CAPM can test Efficient Market Hypothesis.
• Market is efficient if only risk-free assets give
  risk-free rates of return (e.g., Treasury bills).
• Deviations may indicate opportunities.
• Modeling predictions can suggest improvements to
  market functioning.

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Lending Borrowing Under the CPM

• Assumption of unlimited lending and borrowing at
  risk-free rate.
• Lending if portion of portfolio held in risk-free
  assets.
• Borrowing (leverage) if more than 100 of
  portfolio is invested in risky assets.
• Superior returns made possible with lending and
  borrowing creates spectrum of risk preference
  for different investors.

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CAPITAL ASSET PRICING MODELThree Linear
Relationships

• Capital Market Line linear risk-return trade-off
  for all investment portfolios
• Security Market Line linear risk-return
  trade-off for individual stocks
• Security Characteristic Line linear relation
  between the return on individual securities and
  the overall market at every point in time

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EXPECTED RETURN RISKThe Capital Market Line
(CML)

• Linear risk-return trade-off for all investment
  portfolios given by

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Security Market Line (SML)

• Security Market Line linear risk-return
  trade-off for individual stocks
• Systematic Risk return volatility tied to
  overall market also called nondiversifiable risk
• Unsystematic Risk return volatility tied
  specifically to an individual company also
  called diversifiable risk
• Beta sensitivity of a securitys returns to the
  systematic market risk factor

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The BETA Factor
Figure 13.5
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The Security Characteristic Line

• Linear relation between the return on individual
  securities and the overall market at every point
  in time, given by

• Positive Abnormal Returns above-average returns
  that cant be explained as compensation for added
  risk
• Negative Abnormal Returns below-average returns
  that cannot be explained by below-market risk

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Empirical Implications of CAPM

• Optimal portfolio choice depends on market
  risk-return trade-offs and individual investors
  differences in risk preferences.
• Relation between expected return and risk is
  linear for all portfolios and individual assets.
• Expected rate of return is risk-free rate plus
  relative risk (ßp) times market risk premium.
• High beta portfolios earn high risk premiums.
• Low beta portfolios earn low risk premiums.
• Stock price ? measures relevant risk for all
  securities.