Chapter 8: An Introduction to

Asset Pricing Models

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 Capital Market Theory: An Overview
• Capital market theory extends portfolio theory
and develops a model for pricing all risky
assets, while capital asset pricing model
(CAPM) will allow you to determine the
required rate of return for any risky asset
• Four Areas
– Background for Capital Market Theory
– Developing the Capital Market Line
– Risk, Diversification, and the Market Portfolio
– Investing with the CML: An Example

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 Background for Capital Market Theory
• Assumptions of Capital Market Theory
– All investors are Markowitz efficient investors who want
to target points on the efficient frontier
– Investors can borrow or lend any amount of money at
the risk-free rate of return (RFR)
– All investors have homogeneous expectations; that is,
they estimate identical probability distributions for
future rates of return
– All investors have the same one-period time horizon
such as one-month, six months, or one year

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 Background for Capital Market Theory
• Assumptions (Continued)
– All investments are infinitely divisible, which means that
it is possible to buy or sell fractional shares of any
asset or portfolio
– There are no taxes or transaction costs involved in
buying or selling assets
– There is no inflation or any change in interest rates, or
inflation is fully anticipated
– Capital markets are in equilibrium, implying that all
investments are properly priced in line with their risk
levels

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 Background for Capital Market Theory
• Development of Capital Market Theory
– The major factor that allowed portfolio theory to
develop into capital market theory is the concept of a
risk-free asset
 An asset with zero standard deviation
 Zero correlation with all other risky assets
 Provides the risk-free rate of return (RFR)
 Will lie on the vertical axis of a portfolio graph

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 Developing the Capital Market Line
• Covariance with a Risk-Free Asset
– Covariance between two sets of returns is
n
Cov ij   [R i - E(R i )][R j - E(R j )]/n
i 1

– Because the returns for the risk free asset are

certain, thus Ri = E(Ri), and Ri - E(Ri) = 0, which means that
the covariance between the risk-free asset and any
risky asset or portfolio will always be zero
– Similarly, the correlation between any risky asset
and the risk-free asset would be zero too since rRF,i=
CovRF, I / σRF σi
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 Developing the Capital Market Line
• Combining a Risk-Free Asset with a Risky
Portfolio, M
– Expected return: It is the weighted average of the
two returns
E(R port )  W RF (RFR)  (1- W RF )E(R M )

– Standard deviation: Applying the two-asset

standard deviation formula, we will have
 port
2
 w RF
2
 RF
2
 (1  w RF ) 2  M2  2 w RF (1- w RF )rRF, M RF M

Since σRF =0, σport =(1-WRF) σM

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 Developing the Capital Market Line
• The Capital Market Line
– With these results, we can develop the risk–return
relationship between E(Rport) and σport

E(R M )  RFR
E(R port )  RFR   port [ ]
M

– This relationship holds for every combination of the

risk-free asset with any collection of risky assets
– However, when the risky portfolio, M, is the market
portfolio containing all risky assets held anywhere in
the marketplace, this linear relationship is called the
Capital Market Line (Exhibit 8.1) 8-8
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 Exhibit 8.1

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 Developing the Capital Market Line
• Risk-Return Possibilities with Leverage
– One can attain a higher expected return than is
available at point M
– One can invest along the efficient frontier beyond
point M, such as point D
– With the risk-free asset, one can add leverage to
the portfolio by borrowing money at the risk-free
rate and investing in the risky portfolio at point M to
achieve a point like E
– Clearly, point E dominates point D
– Similarly, one can reduce the investment risk by
lending money at the risk-free asset to reach points
like C (see Exhibit 8.2)
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 Exhibit 8.2

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 Risk, Diversification & the Market Portfolio
• The Market Portfolio
– Because portfolio M lies at the point of tangency, it
has the highest portfolio possibility line
– Everybody will want to invest in Portfolio M and
borrow or lend to be somewhere on the CML
– It must include ALL RISKY ASSETS
– Since the market is in equilibrium, all assets in this
portfolio are in proportion to their market values
– Because it contains all risky assets, it is a
completely diversified portfolio, which means that all
the unique risk of individual assets (unsystematic
risk) is diversified away

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 Risk, Diversification & the Market Portfolio
• Systematic Risk
– Only systematic risk remains in the market portfolio
– Systematic risk is the variability in all risky assets
caused by macroeconomic variables
 Variability in growth of money supply
 Interest rate volatility
 Variability in factors like (1) industrial production (2)
corporate earnings (3) cash flow
– Systematic risk can be measured by the standard
deviation of returns of the market portfolio and can
change over time

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 Risk, Diversification & the Market Portfolio
• How to Measure Diversification
– All portfolios on the CML are perfectly positively
correlated with each other and with the completely
diversified market Portfolio M
– That is, a completely diversified portfolio would
have a correlation with the market portfolio of +1.00
– The reason is that complete risk diversification
means the elimination of all the unsystematic or
unique risk and the systematic risk correlates
perfectly with the market portfolio

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 Risk, Diversification & the Market Portfolio
• Diversification and the Elimination of
Unsystematic Risk
– The purpose of diversification is to reduce the
standard deviation of the total portfolio
– This assumes that imperfect correlations exist
among securities
– As you add securities, you expect the average
covariance for the portfolio to decline
– How many securities must you add to obtain a
completely diversified portfolio?
– See Exhibit 8.3

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 Exhibit 8.3

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 Risk, Diversification & the Market Portfolio
• The CML and the Separation Theorem
– The CML leads all investors to invest in the M
portfolio
– Individual investors should differ in position on the
CML depending on risk preferences
– How an investor gets to a point on the CML is
based on financing decisions
– Risk averse investors will lend at the risk-free rate
while investors preferring more risk might borrow
funds at the RFR and invest in the market portfolio
– The investment decision of choosing the point on
CML is separate from the financing decision of
reaching there through either lending or borrowing 8-17
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 Risk, Diversification & the Market Portfolio
• A Risk Measure for the CML
– The Markowitz portfolio model considers the
average covariance with all other assets
– The only important consideration is the asset’s
covariance with the market portfolio
– Covariance with the market portfolio is the
systematic risk of an asset
– Variance of a risky asset i
Var (Rit)= Var (biRMt)+ Var(ε)
=Systematic Variance + Unsystematic Variance
where bi= slope coefficient for asset i
ε = random error term
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 8-19
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