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Chapter 13

The document discusses the standard capital asset pricing model (CAPM), including its assumptions, derivation, and implications. It outlines ten key assumptions of CAPM, such as no transaction costs or taxes. It then derives the CAPM formula that the expected return of any asset is equal to the risk-free rate plus a risk premium that is proportional to the asset's systematic risk or beta.

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Md Tanvir Hasan
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33 views22 pages

Chapter 13

The document discusses the standard capital asset pricing model (CAPM), including its assumptions, derivation, and implications. It outlines ten key assumptions of CAPM, such as no transaction costs or taxes. It then derives the CAPM formula that the expected return of any asset is equal to the risk-free rate plus a risk premium that is proportional to the asset's systematic risk or beta.

Uploaded by

Md Tanvir Hasan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Portfolio Management

The Standard Capital Asset


Pricing Model
• The construction of general equilibrium models will allow us to determine the relevant
measure of risk for any asset and the relationship between expected return and risk for any
asset when markets are in equilibrium.
• The simplest form of an equilibrium model is called the standard capital asset pricing
model (CAPM), or the one-factor capital asset pricing model.
• This was the first general equilibrium model developed and is based on the most stringent
set of assumptions.
• Many of CAPM’s assumptions are objectionable.
• Furthermore, the final model is so simple.
• Despite the stringent assumptions and the simplicity of the model, it amazingly describes
prices in the capital markets.
THE ASSUMPTIONS UNDERLYING THE STANDARD
CAPITAL ASSET PRICING MODEL (CAPM)
• The real world is sufficiently complex that to understand it and construct models of how it
works, one must assume away those complexities that are thought to have only a small (or
no) effect on its behavior.

• The first assumption we make is that there are no transaction costs.


• There is no cost (friction) of buying or selling any asset.
• The second assumption behind the CAPM is that assets are infinitely divisible.
• This means that investors could take any position in an investment, regardless of the size of their wealth.
• The third assumption is the absence of personal income tax.
• This means, for example, that the individual is indifferent to the form (dividends or capital gains) in
which the return on the investment is received.
THE ASSUMPTIONS UNDERLYING THE STANDARD
CAPITAL ASSET PRICING MODEL (CAPM)
• The real world is sufficiently complex that to understand it and construct models of how it
works, one must assume away those complexities that are thought to have only a small (or
no) effect on its behavior.

• The fourth assumption is that an individual cannot affect the price of a stock by his
buying or selling action.
• This is analogous to the assumption of perfect competition
• The fifth assumption is that investors are expected to make decisions solely in terms of
expected values and standard deviations of the returns on their portfolios.
• The sixth assumption is that unlimited short sales are allowed.
• The seventh assumption is unlimited lending and borrowing at the riskless rate.
THE ASSUMPTIONS UNDERLYING THE STANDARD
CAPITAL ASSET PRICING MODEL (CAPM)
• The real world is sufficiently complex that to understand it and construct models of how it
works, one must assume away those complexities that are thought to have only a small (or
no) effect on its behavior.

• The eighth and ninth assumptions deal with the homogeneity of expectations.
• First, investors are assumed to be concerned with the mean and variance of returns (or prices over a single
period), and all investors are assumed to define the relevant period in exactly the same manner.
• Second, all investors are assumed to have identical expectations with respect to the necessary inputs to the
portfolio decision: are expected returns, the variance of returns, and the correlation matrix representing
the correlation structure between all pairs of stocks.
• The tenth assumption is that all assets are marketable.
• All assets, including human capital, can be sold and bought on the market.
THE CAPM
• The standard form of the general equilibrium relationship for asset returns was developed
independently by Sharpe, Lintner, and Mossin.
• Hence it is often referred to as the Sharpe–Lintner–Mossin form of the capital asset pricing model.
Deriving the CAPM—A Simple Approach
• In the presence of short sales, but without riskless lending and borrowing, each investor
faced an efficient frontier such as that shown below.

• In this figure, BC represents the efficient


frontier, while ABC represents the set of
minimum-variance portfolios
Deriving the CAPM—A Simple Approach
• If all investors have homogeneous expectations and they all face the same lending and
borrowing rate, then they will each face a diagram such as in Figure 13.2.
• The portfolio of risky assets Pi held by any investor will be identical to the portfolio of risky
assets held by any other investor.
• If all investors hold the same risky portfolio, then, in
equilibrium, it must be the market portfolio.
• The market portfolio is a portfolio comprising all
risky assets. Each asset is held in the proportion that
the market value of that asset represents of the total
market value of all risky assets.
• For example, if IBM stock represents 3% of all risky
assets, then the market portfolio contains 3% IBM
stock, and each investor will take 3% of the money
that will be invested in all risky assets and place it in
IBM stock.
Deriving the CAPM—A Simple Approach
• All investors will hold combinations of only two portfolios: the market portfolio (M) and a
riskless security.
• This is sometimes referred to as the two mutual fund theorem because all investors would
be satisfied with a market fund, plus the ability to lend or borrow a riskless security.

• The straight line depicted in Figure 13.2 is usually referred to as the capital market line.
• All investors will end up with portfolios somewhere along the capital market line, and all
efficient portfolios would lie along the capital market line.
• However, not all securities or portfolios lie along the capital market line.
• By looking at the capital market line, we can learn something about the market price of risk.
Deriving the CAPM—A Simple Approach
• can be thought of as the market price of risk for all efficient portfolios.

• It is the extra return that can be gained by increasing the level of risk (standard deviation) on
an efficient portfolio by one unit.

• The first term is simply the price of time or the return that is required for delaying potential
consumption, one period given perfect certainty about the future cash flow.
• The second term represents the market price of risk times the amount of risk in a portfolio.

• This equation establishes the return on an efficient portfolio, but does not describe
equilibrium returns on non-efficient portfolios or on individual securities
Deriving the CAPM—A Simple Approach
• For very well-diversified portfolios, nonsystematic risk tends to go to zero, and the only
relevant risk is systematic risk measured by beta.
• Also given the assumptions of homogeneous expectations and unlimited riskless lending
and borrowing, all investors will hold the market portfolio.
• Thus the investor will hold a very well-diversified portfolio.
• Because we assume that the investor is concerned only with expected return and risk, the
only dimensions of a security that need be of concern are expected return and beta.
• Let us hypothesize two portfolios with the characteristics shown here:

• Now consider a portfolio C made up of one-half of portfolio A and one-half of portfolio B.


• The expected return on this portfolio is 11, and its beta is 1.2
Deriving the CAPM—A Simple Approach
Deriving the CAPM—A Simple Approach
• As long as a security lies above/below the straight line, there is a portfolio involving zero
risk and zero net investment that has a positive expected profit.
• An investor will engage in this arbitrage as long as any security or portfolio lies
above/below the straight line depicted in Figure 13.3.
• We have now established that all investments and all portfolios of investments must lie
along a straight line in return-beta space.
• If any investment were to lie above or below that straight line, then an opportunity would
exist for riskless arbitrage.
• This arbitrage would continue until all investments converged to the line.
Deriving the CAPM—A Simple Approach
• The market portfolio is point M with a beta of 1 and an expected return of .
• The intercept occurs when beta equals zero, or when the asset has zero systematic risk.
• One asset with zero systematic risk is the riskless asset.
Deriving the CAPM—A Simple Approach
• The simple equation is called the security market line, that describes the expected return
for all assets and portfolios of assets in the economy.
• The expected return on any asset, or portfolio, whether it is efficient or not, can be
determined from this relationship.
• The relationship between the expected return on any two assets can be related simply to
their difference in beta.
• The higher beta is for any security, the higher must be its equilibrium return.
• Furthermore, the relationship between beta and expected return is linear.
• The CAPM is an equilibrium relationship.
• High-beta stocks are expected to give a higher return than low-beta stocks because they are
more risky.
• This does not mean that they will give a higher return over all intervals of time.
• In fact, if they always gave a higher return, they would be less risky, not more risky, than low-beta stocks.
Rather, because they are more risky, they will sometimes produce lower returns. However, over long
periods of time, they should on the average produce higher returns
Deriving the CAPM—A Simple Approach
• The CAPM model:

• We could then write the security market line as:

• The security market line, like the capital market line, states that the expected return on any
security is the riskless rate of interest plus the market price of risk times the amount of risk
in the security or portfolio
PRICES AND THE CAPM
PRICES AND THE CAPM
PRICES AND THE CAPM
PRICES AND THE CAPM

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