The Capital Asset Pricing Model Capm75

INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth W. Sean Cleary
Chapter 9 The Capital Asset Pricing

Model
Prepared by
Ken Hartviksen
CHAPTER 9
The Capital Asset Pricing
Model (CAPM)
Lecture Agenda
Learning Objectives
Important Terms
The New Efficient Frontier
The Capital Asset Pricing Model
The CAPM and Market Risk
Alternative Asset Pricing Models
Summary and Conclusions
Concept Review Questions

Appendix 1 Calculating the Ex Ante Beta
Appendix 2 Calculating the Ex Post Beta
CHAPTER 9 The Capital Asset Pricing
Model (CAPM)
9-3
Learning Objectives
1. What happens if all investors are rational and risk averse.
2. How modern portfolio theory is extended to develop the
capital market line, which determines how expected
returns on portfolios are determined.
3. How to assess the performance of mutual fund managers
4. How the Capital Asset Pricing Models (CAPM) security
market line is developed from the capital market line.
5. How the CAPM has been extended to include other riskbased pricing models.

Model (CAPM)
9-4
Important Chapter Terms

Arbitrage pricing theory
(APT)
Capital Asset Pricing
Model (CAPM)
Capital market line
(CML)
Characteristic line
Fama-French (FF) model
Insurance premium
Market portfolio
Market price of risk
Market risk premium

New (or super) efficient
frontier
No-arbitrage principle
Required rate of return
Risk premium
Security market line
(SML)
Separation theorum
Sharpe ratio
Short position
Tangent portfolio

Model (CAPM)
9-5
Achievable Portfolio Combinations

(CAPM)

The Two-Asset Case
It is possible to construct a series of portfolios with

different risk/return characteristics just by varying the
weights of the two assets in the portfolio.
Assets A and B are assumed to have a correlation
coefficient of -0.379 and the following individual
return/risk characteristics
Asset A
Asset B
Expected Return
8%
10%
Standard Deviation
8.72%
22.69%
The following table shows the portfolio characteristics for 100

different weighting schemes for just these two securities:
Model (CAPM)
9-7
Example of Portfolio Combinations and

Correlation
You repeat this
procedure
down until you
have determine
the portfolio
characteristics
The first
for all
100
The
second
combination
portfolios.
portfolio
simply99%
assumes
Next
plot1%
the
in
A and
in
assumes
you
returns
onthe
a
B.
Notice
invest
solely
graph
(see in
the
increase
in
Asset
A
next
slide)
return
and
the
decrease in
portfolio risk!

Model (CAPM)
9-8
Example of Portfolio Combinations and

Correlation

Model (CAPM)
9-9
Two Asset Efficient Frontier

Figure 8 10 describes five different portfolios
(A,B,C,D and E in reference to the attainable
set of portfolio combinations of this two asset
portfolio.
(See Figure 8 -10 on the following slide)

Model (CAPM)
9 - 10
Efficient Frontier
The Two-Asset Portfolio Combinations
8 - 10 FIGURE
A is not attainable
B,E lie on the
Expected Return %
efficient frontier and

are attainable
E is the minimum
B
C
variance portfolio
(lowest risk
combination)
C, D are
E
D
Standard Deviation (%)

Model (CAPM)
attainable but are

dominated by
superior portfolios
that line on the line
above E
9 - 11
Achievable Set of Portfolio Combinations

Getting to the n Asset Case
In a real world investment universe with all of the

investment alternatives (stocks, bonds, money
market securities, hybrid instruments, gold real
estate, etc.) it is possible to construct many
different alternative portfolios out of risky
securities.
Each portfolio will have its own unique expected
return and risk.
Whenever you construct a portfolio, you can
measure two fundamental characteristics of the
portfolio:
Portfolio expected return (ERp)
Portfolio risk (p)
Model (CAPM)
9 - 12
The Achievable Set of Portfolio

Combinations
You could start by randomly assembling ten
risky portfolios.
The results (in terms of ER p and p )might
look like the graph on the following page:

Model (CAPM)
9 - 13

The First Ten Combinations Created
ERp
10 Achievable
Risky Portfolio
Combinations
Portfolio Risk (p)

Model (CAPM)
9 - 14
The Achievable Set of Portfolio

Combinations
You could continue randomly assembling
more portfolios.
Thirty risky portfolios might look like the
graph on the following slide:

Model (CAPM)
9 - 15

Thirty Combinations Naively Created
ERp
30 Risky Portfolio
Combinations
Portfolio Risk (p)

Model (CAPM)
9 - 16
Achievable Set of Portfolio Combinations

All Securities Many Hundreds of Different Combinations
When you construct many hundreds of

different portfolios naively varying the weight
of the individual assets and the number of
types of assets themselves, you get a set of
achievable portfolio combinations as
indicated on the following slide:

Model (CAPM)
9 - 17

More Possible Combinations Created
ERp
E is the
minimum
variance
portfolio
Achievable Set of
Risky Portfolio
Combinations
The highlighted
portfolios are
efficient in that
they offer the
highest rate of
return for a given
level of risk.
Rationale investors
will choose only
from this efficient
set.
Portfolio Risk (p)

Model (CAPM)
9 - 18
The Efficient Frontier

(CAPM)

Efficient Frontier (Set)
ERp
Achievable Set of
Risky Portfolio
Combinations
Efficient
frontier is the
set of
achievable
portfolio
combinations
that offer the
highest rate
of return for a
given level of
risk.
Portfolio Risk (p)

Model (CAPM)
9 - 20

Efficient Portfolios
9 - 1 FIGURE
Efficient Frontier
ER
B
A
MVP
Risk

Model (CAPM)
Figure 9 1
illustrates
three
achievable
portfolio
combinations
that are
efficient (no
other
achievable
portfolio that
offers the
same risk,
offers a higher
return.)
9 - 21
Underlying Assumption
Investors are Rational and Risk-Averse
We assume investors are risk-averse wealth

maximizers.
This means they will not willingly undertake fair gamble.
A risk-averse investor prefers the risk-free situation.

The corollary of this is that the investor needs a risk premium to be
induced into a risky situation.
Evidence of this is the willingness of investors to pay insurance
premiums to get out of risky situations.
The implication of this, is that investors will only choose

portfolios that are members of the efficient set
(frontier).
Model (CAPM)
9 - 22
The New Efficient Frontier and

Separation Theorem
(CAPM)
Risk-free Investing
When we introduce the presence of a risk-free
investment, a whole new set of portfolio
combinations becomes possible.
We can estimate the return on a portfolio
made up of RF asset and a risky asset A
letting the weight w invested in the risky
asset and the weight invested in RF as (1 w)

Model (CAPM)
9 - 24

Risk-Free Investing
Expected return on a two asset portfolio made up of

risky asset A and RF:
[9-1]
ER p RF w (ER A - RF)
The possible combinations of A and RF are found graphed on the following slide.

Model (CAPM)
9 - 25

Attainable Portfolios Using RF and A
9 - 2 FIGURE
ER
[9-3]
pA
E(R
)-w
RF A
P
ER P[9-2]
RF
RF
Risk

Model (CAPM)
This means
you
can 9 2
Equation
Rearranging
9
achieve
any
illustrates
-2 where w=
portfolio
what
you can
p / A and
combination
seeportfolio
substituting in
along
the blue
risk
increases
Equation
1 we
coloured
line
in
getdirect
an
simply
by to
proportion
equation for a
changing
the
the
amount
straight
line
relative
weight
invested
with a in the
of
RFasset.
and A in
risky
constant
the two asset
slope.
portfolio.
9 - 26

Attainable Portfolios using the RF and A, and RF and T
9 - 3 FIGURE
Which risky
portfolio
would a
rational riskaverse
investor
choose in the
presence of a
RF
investment?
ER
T
A
RF
Portfolio A?
Risk

Model (CAPM)
Tangent
Portfolio T?
9 - 27

Efficient Portfolios using the Tangent Portfolio T
9 - 3 FIGURE
ER
T
A
RF
Risk

Model (CAPM)
Clearly RF with
T (the tangent
portfolio) offers
a series of
portfolio
combinations
that dominate
those produced
by RF and A.
Further, they
dominate all but
one portfolio on
the efficient
frontier!
9 - 28

Lending Portfolios
9 - 3 FIGURE
ER
Lending Portfolios
T
A
RF
Portfolios
between RF
and T are
lending
portfolios,
because they
are achieved by
investing in the
Tangent
Portfolio and
lending funds to
the government
(purchasing a Tbill, the RF).
Risk

Model (CAPM)
9 - 29

Borrowing Portfolios
9 - 3 FIGURE
ER
Lending Portfolios Borrowing Portfolios
T
A
RF
The line can be

extended to risk
levels beyond
T by
borrowing at RF
and investing it
in T. This is a
levered
investment that
increases both
risk and
expected return
of the portfolio.
Risk

Model (CAPM)
9 - 30

The New (Super) Efficient Frontier
9 - 4 FIGURE
Capital Market Line

ER
B2
T
A2
RF

Model (CAPM)
This is now
called
Clearlythe
RFnew
with
(or
super)
T (the
market
The optimal
efficient
frontier
portfolio)
offers
risky portfolio
of
risky
a series
of
(the market
portfolios.
portfolio
portfolio M)
combinations
Investors can
that dominate
achieve any
those produced
one of these
by RF and A.
portfolio
combinations
Further, they by
borrowing
or but
dominate all
investing
in RF
one portfolio
on
in
thecombination
efficient
with
the market
frontier!
portfolio.
9 - 31
The Implications Separation Theorem Market Portfolio
All investors will only hold individually-determined

combinations of:
The risk free asset (RF) and
The model portfolio (market portfolio)
The separation theorem
The investment decision (how to construct the portfolio of risky

assets) is separate from the financing decision (how much
should be invested or borrowed in the risk-free asset)
The tangent portfolio T is optimal for every investor regardless of
his/her degree of risk aversion.
The Equilibrium Condition
The market portfolio must be the tangent portfolio T if everyone

holds the same portfolio
Therefore the market portfolio (M) is the tangent portfolio (T)
Model (CAPM)
9 - 32

The Capital Market Line
The CML is that

set of superior
The optimal
portfolio
risky portfolio
combinations
(the market
that
are M)
portfolio
achievable in
the presence of
the equilibrium
condition.
CML
ER
RF

Model (CAPM)
9 - 33

The Hypothesized Relationship
between Risk and Return

What is it?
An hypothesis by Professor William Sharpe

Hypothesizes that investors require higher rates of return for greater levels of
relevant risk.
There are no prices on the model, instead it hypothesizes the relationship
between risk and return for individual securities.
It is often used, however, the price securities and investments.

Model (CAPM)
9 - 35

How is it Used?
Uses include:
Determining the cost of equity capital.
The relevant risk in the dividend discount model to estimate a stocks intrinsic
(inherent economic worth) value. (As illustrated below)
Estimate Investments
Risk (Beta Coefficient)
COVi,M
M2
Determine Investments
Required Return
ki RF ( ERM RF ) i
Estimate the
Investments Intrinsic
Value
D1
P0
kc g

Model (CAPM)
Compare to the actual

stock price in the
market
Is the stock
fairly priced?
9 - 36

Assumptions
CAPM is based on the following assumptions:

1. All investors have identical expectations about expected
returns, standard deviations, and correlation coefficients for all
securities.
2. All investors have the same one-period investment time
horizon.
3. All investors can borrow or lend money at the risk-free rate of
return (RF).
4. There are no transaction costs.
5. There are no personal income taxes so that investors are
indifferent between capital gains an dividends.
6. There are many investors, and no single investor can affect
the price of a stock through his or her buying and selling
decisions. Therefore, investors are price-takers.
7. Capital markets are in equilibrium.
Model (CAPM)
9 - 37
Market Portfolio and Capital Market Line

The assumptions have the following
implications:
1. The optimal risky portfolio is the one that is
tangent to the efficient frontier on a line that is drawn
from RF. This portfolio will be the same for all
investors.
2. This optimal risky portfolio will be the market
portfolio (M) which contains all risky securities.
(Figure 9 4 illustrates the Market Portfolio M)

Model (CAPM)
9 - 38

9 - 5 FIGURE
ER
CML
ERM
ERM RF
k P RF
P
M
RF
The CML is that

setThe
of achievable
market
portfolio
The
portfolio
CMLishas
the
combinations
optimal
standard
risky
that
deviation
portfolio,
are possible
of
it
contains
portfolio
when investing
all
returns
risky
in as
only
the
two
securities
and
lies
independent
assets
tangent
(the(T)
market
on variable.
the efficient
portfolio
and the
frontier.
risk-free
asset (RF).

Model (CAPM)
9 - 39

The Market Portfolio and the Capital Market Line (CML)
The slope of the CML is the incremental expected

return divided by the incremental risk.
[9-4]
Slope of the CML
ER M - RF
M
This is called the market price for risk. Or

The equilibrium price of risk in the capital market.
Model (CAPM)
9 - 40

The Market Portfolio and the Capital Market Line (CML)
Solving for the expected return on a portfolio in the presence of
a RF asset and given the market price for risk :
[9-5]
ERM - RF
E ( RP ) RF
P
M
Where:
ERM = expected return on the market portfolio M
M = the standard deviation of returns on the market portfolio
P = the standard deviation of returns on the efficient portfolio being
considered
Model (CAPM)
9 - 41

Using the CML Expected versus Required Returns
In an efficient capital market investors will require a

return on a portfolio that compensates them for the
risk-free return as well as the market price for risk.
This means that portfolios should offer returns along
the CML.

Model (CAPM)
9 - 42

Expected and Required Rates of Return
9 - 6 FIGURE
Required
Return on C
ER
Expected
return on A
Required
return on A
RF
CML
A
C
B
Expected
Return on C

Model (CAPM)
C is an
A
B
a portfolio
overvalued
that
undervalued
offers
portfolio.
andExpected
expected
portfolio.
return
equal
is
less
Expected
tothan
the
return
required
the
required
is greater
return.
return.
than the required
Selling pressure
return.
will cause the price
Demand
to
fall andfor
the yield
Portfolio
to
rise until
A will
increase driving
expected
equalsup
the required
price, andreturn.
therefore the
expected return will
fall until expected
equals required
(market equilibrium
condition is
achieved.)
9 - 43

Risk-Adjusted Performance and the Sharpe Ratios
William Sharpe identified a ratio that can be used to assess the risk-adjusted
performance of managed funds (such as mutual funds and pension plans).
It is called the Sharpe ratio:
[9-6]
Sharpe ratio
ER P - RF
P
Sharpe ratio is a measure of portfolio performance that describes how well

an assets returns compensate investors for the risk taken.
Its value is the premium earned over the RF divided by portfolio riskso it is
measuring valued added per unit of risk.
Sharpe ratios are calculated ex post (after-the-fact) and are used to rank
portfolios or assess the effectiveness of the portfolio manager in adding
value to the portfolio over and above a benchmark.

Model (CAPM)
9 - 44

Sharpe Ratios and Income Trusts
Table 9 1 (on the following slide) illustrates return,

standard deviation, Sharpe and beta coefficient for
four very different portfolios from 2002 to 2004.
Income Trusts did exceedingly well during this time,
however, the recent announcement of Finance
Minister Flaherty and the subsequent drop in Income
Trust values has done much to eliminate this
historical performance.

Model (CAPM)
9 - 45
Income Trust Estimated Values

Model (CAPM)
9 - 46
CAPM and Market Risk

Diversifiable and Non-Diversifiable Risk

CML applies to efficient portfolios
Volatility (risk) of individual security returns are
caused by two different factors:
Non-diversifiable risk (system wide changes in the economy and
markets that affect all securities in varying degrees)
Diversifiable risk (company-specific factors that affect the returns
of only one security)
Figure 9 7 illustrates what happens to portfolio risk

as the portfolio is first invested in only one
investment, and then slowly invested, naively, in more
and more securities.
Model (CAPM)
9 - 48

Portfolio Risk and Diversification
9 - 7 FIGURE
Total Risk ()
Unique (Non-systematic) Risk
Market (Systematic) Risk
Market or
systematic
risk is risk
that cannot
be eliminated
from the
portfolio by
investing the
portfolio into
more and
different
securities.
Number of Securities

Model (CAPM)
9 - 49
Relevant Risk
Drawing a Conclusion from Figure 9 - 7
Figure 9 7 demonstrates that an individual securities

volatility of return comes from two factors:
Systematic factors
Company-specific factors
When combined into portfolios, company-specific risk

is diversified away.
Since all investors are diversified then in an efficient
market, no-one would be willing to pay a premium
for company-specific risk.
Relevant risk to diversified investors then is systematic
risk.
Systematic risk is measured using the Beta Coefficient.
Model (CAPM)
9 - 50
Measuring Systematic Risk

The Beta Coefficient
(CAPM)

What is the Beta Coefficient?
A measure of systematic (non-diversifiable)

risk
As a coefficient the beta is a pure number
and has no units of measure.

Model (CAPM)
9 - 52

How Can We Estimate the Value of the Beta Coefficient?
There are two basic approaches to

estimating the beta coefficient:
1. Using a formula (and subjective forecasts)
2. Use of regression (using past holding period returns)
(Figure 9 8 on the following slide illustrates the characteristic line used to estimate
the beta coefficient)

Model (CAPM)
9 - 53

The Characteristic Line for Security A
9 - 8 FIGURE
Security A Returns (%)
-6
-4
-2
0
0
-2
-4
Market Returns (%)
The
Theslope
plotted
of
the
points
regression
are the
line
coincident
is beta.
rates of return
earned
The line
on of
the
investment
best fit is
andknown
the market
in
finance
portfolioasover
the
characteristic
past periods.
line.
-6

Model (CAPM)
9 - 54
The Formula for the Beta Coefficient

Beta is equal to the covariance of the returns of the
stock with the returns of the market, divided by the
variance of the returns of the market:
[9-7]
COVi,M i , M i
i
2
M
M

Model (CAPM)
9 - 55

How is the Beta Coefficient Interpreted?
The beta of the market portfolio is ALWAYS = 1.0
The beta of a security compares the volatility of its returns to the volatility of
the market returns:
s = 1.0
the security has the same volatility as the market as a

whole
s > 1.0
aggressive investment with volatility of returns greater than

the market
s < 1.0
defensive investment with volatility of returns less than the

market
s < 0.0
an investment with returns that are negatively correlated

with the returns of the market
Table 9 2 illustrates beta coefficients for a variety of Canadian Investments

Model (CAPM)
9 - 56
Canadian BETAS
Selected

Model (CAPM)
9 - 57
The Beta of a Portfolio

The beta of a portfolio is simply the weighted average of the
betas of the individual asset betas that make up the portfolio.
[9-8]
P wA A wB B ... wn n
Weights of individual assets are found by dividing the value of

the investment by the value of the total portfolio.

Model (CAPM)
9 - 58
The Security Market Line

(CAPM)

The Security Market Line (SML)
The SML is the hypothesized relationship between return (the
dependent variable) and systematic risk (the beta coefficient).
It is a straight line relationship defined by the following formula:
[9-9]
ki RF ( ERM RF ) i
Where:
ki = the required return on security i
ERM RF = market premium for risk
i = the beta coefficient for security i
(See Figure 9 - 9 on the following slide for the graphical representation)

Model (CAPM)
9 - 60

The Security Market Line (SML)
9 - 9 FIGURE
ER
ERM
ki RF ( ERM RF ) i
TheSML
SMLis
The
uses
usedthe
to
beta
predict
coefficient
requiredas
the
measure
returns
for
of
relevant
individual
risk.
securities
RF
M = 1

Model (CAPM)
9 - 61

The SML and Security Valuation
9 - 10 FIGURE
ki RF ( ERM RF ) i
ER
SML
Expected
Return A
Required
Return A
RF

Model (CAPM)
Similarly,
Required
A
is an B
returns
is an
are forecast using
undervalued
overvalued
this equation.
security
security.
because
its expected return
You can see
Investors
willthat
sell
is greater than the
thelock
to
required
in gains,
return
required return.
on any
but
the security
selling is
a functionwill
Investors
pressure
will
of its
systematic
flock
cause
to
the
A market
and
risk bid
()
andthe
up
price
market
toprice
fall,
factors the
causing
expected
(RF and
market
return
expected
to fall
return
till itto
premium
equals
rise
untilthe
it equals
for
risk)
required
the
required
return.
return.
9 - 62
The CAPM in Summary

The SML and CML
The CAPM is well entrenched and widely used by

investors, managers and financial institutions.
It is a single factor model because it based on the
hypothesis that required rate of return can be
predicted using one factor systematic risk
The SML is used to price individual investments and
uses the beta coefficient as the measure of risk.
The CML is used with diversified portfolios and uses
the standard deviation as the measure of risk.
Model (CAPM)
9 - 63
Alternative Pricing Models

(CAPM)
Challenges to CAPM
Empirical tests suggest:
CAPM does not hold well in practice:
Ex post SML is an upward sloping line
Ex ante y (vertical) intercept is higher that RF
Slope is less than what is predicted by theory
Beta possesses no explanatory power for predicting stock returns

(Fama and French, 1992)
CAPM remains in widespread use despite the foregoing.

Advantages include relative simplicity and intuitive logic.
Because of the problems with CAPM, other models have

been developed including:
Fama-French (FF) Model
Abitrage Pricing Theory (APT)
Model (CAPM)
9 - 65

The Fama French Model
A pricing model that uses three factors to relate

expected returns to risk including:
1. A market factor related to firm size.
2. The market value of a firms common equity (MVE)
3. Ratio of a firms book equity value to its market value of equity.
(BE/MVE)
This model has become popular, and many think it

does a better job than the CAPM in explaining ex
ante stock returns.

Model (CAPM)
9 - 66

The Arbitrage Pricing Theory
A pricing model that uses multiple factors to relate expected
returns to risk by assuming that asset returns are linearly related
to a set of indexes, which proxy risk factors that influence
security returns.
[9-10]
ERi a0 bi1 F1 bi1 F1 ... bin Fn
It is based on the no-arbitrage principle which is the rule that two

otherwise identical assets cannot sell at different prices.
Underlying factors represent broad economic forces which are
inherently unpredictable.

Model (CAPM)
9 - 67

The Arbitrage Pricing Theory the Model
Underlying factors represent broad economic forces which are
inherently unpredictable.
[9-10]
ERi a0 bi1 F1 bi1 F1 ... bin Fn
Where:
ERi = the expected return on security i

a0 = the expected return on a security with zero systematic risk
bi = the sensitivity of security i to a given risk factor
Fi = the risk premium for a given risk factor
The model demonstrates that a securitys risk is based on its sensitivity

to broad economic forces.
Model (CAPM)
9 - 68

The Arbitrage Pricing Theory Challenges
Underlying factors represent broad economic forces

which are inherently unpredictable.
Ross and Roll identify five systematic factors:
1.
2.
3.
4.
5.
Changes in expected inflation

Unanticipated changes in inflation
Unanticipated changes in industrial production
Unanticipated changes in the default-risk premium
Unanticipated changes in the term structure of interest rates
Clearly, something that isnt forecast, cant be used

to price securities todaythey can only be used to
explain prices after the fact.
Model (CAPM)
9 - 69
Summary and Conclusions

In this chapter you have learned:
How the efficient frontier can be expanded by introducing riskfree borrowing and lending leading to a super efficient frontier
called the Capital Market Line (CML)
The Security Market Line can be derived from the CML and
provides a way to estimate a market-based, required return for
any security or portfolio based on market risk as measured by
the beta.
That alternative asset pricing models exist including the FamaFrench Model and the Arbitrage Pricing Theory.
Model (CAPM)
9 - 70
Concept Review Questions

Concept Review Question 1

Risk Aversion
What is risk aversion and how do we know

investors are risk averse?

Model (CAPM)
9 - 72
Estimating the Ex Ante (Forecast) Beta

APPENDIX 1
Calculating a Beta Coefficient Using Ex Ante

Returns
Ex Ante means forecast
You would use ex ante return data if historical rates of
return are somehow not indicative of the kinds of
returns the company will produce in the future.
A good example of this is Air Canada or American
Airlines, before and after September 11, 2001. After
the World Trade Centre terrorist attacks, a
fundamental shift in demand for air travel occurred.
The historical returns on airlines are not useful in
estimating future returns.

Model (CAPM)
9 - 74
Appendix 1 Agenda
The beta coefficient
The formula approach to beta measurement
using ex ante returns
Ex ante returns
Finding the expected return
Determining variance and standard deviation
Finding covariance
Calculating and interpreting the beta coefficient

Model (CAPM)
9 - 75

Under the theory of the Capital Asset Pricing Model total
risk is partitioned into two parts:
Systematic risk
Unsystematic risk diversifiable risk
Total Risk of the Investment
Systematic Risk
Unsystematic Risk
Systematic risk is non-diversifiable risk.

Systematic risk is the only relevant risk to the
diversified investor
The beta coefficient measures systematic risk
Model (CAPM)
9 - 76

The Formula
Beta
Covariance of Returns between stock ' i' returns and the market
Variance of the Market Returns
[9-7]
COVi,M i , M i
i
2
M
M

Model (CAPM)
9 - 77
The Term Relevant Risk

What does the term relevant risk mean in the context of the CAPM?
It is generally assumed that all investors are wealth maximizing risk

averse people
It is also assumed that the markets where these people trade are highly
efficient
In a highly efficient market, the prices of all the securities adjust instantly
to cause the expected return of the investment to equal the required
return
When E(r) = R(r) then the market price of the stock equals its inherent
worth (intrinsic value)
In this perfect world, the R(r) then will justly and appropriately
compensate the investor only for the risk that they perceive as
relevant
Hence investors are only rewarded for systematic risk.
NOTE: The amount of systematic risk varies by investment. High systematic risk
occurs when R-square is high, and the beta coefficient is greater than 1.0

Model (CAPM)
9 - 78
The Proportion of Total Risk that is Systematic

Every investment in the financial markets vary with
respect to the percentage of total risk that is systematic.
Some stocks have virtually no systematic risk.
Such stocks are not influenced by the health of the economy in

generaltheir financial results are predominantly influenced by
company-specific factors.
An example is cigarette companiespeople consume cigarettes
because they are addictedso it doesnt matter whether the
economy is healthy or notthey just continue to smoke.
Some stocks have a high proportion of their total risk

that is systematic
Returns on these stocks are strongly influenced by the health of the

economy.
Durable goods manufacturers tend to have a high degree of
systematic risk.

Model (CAPM)
9 - 79
The Formula Approach to Measuring the Beta
Cov(k i k M )
Beta
Var(k M )
You need to calculate the covariance of the returns between the
stock and the marketas well as the variance of the market
returns. To do this you must follow these steps:
Calculate the expected returns for the stock and the market
Using the expected returns for each, measure the variance
and standard deviation of both return distributions
Now calculate the covariance
Use the results to calculate the beta
Model (CAPM)
9 - 80
Ex ante Return Data

A Sample
A set of estimates of possible returns and their respective
probabilities looks as follows:

Model (CAPM)
Since the beta

relates the stock
By
observation
returns
to the
market
returns,
you can
see the
the
greater
range
range
is much
of stock returns
greater
for the
changing in the
stock
than theas
same direction
market
and they
the market
indicates
the beta
move in the
will
be direction.
greater
same
than 1 and will be
positive.
(Positively
correlated to the
market returns.)
9 - 81
The Total of the Probabilities must Equal 100%

This means that we have considered all of the possible outcomes
in this discrete probability distribution

Model (CAPM)
9 - 82
Measuring Expected Return on the Stock

From Ex Ante Return Data
The expected return is weighted average returns from
the given ex ante data

Model (CAPM)
9 - 83
Measuring Expected Return on the Market

From Ex Ante Return Data
The expected return is weighted average returns from
the given ex ante data

Model (CAPM)
9 - 84
Measuring Variances, Standard Deviations of

the Forecast Stock Returns
Using the expected return, calculate the deviations away from the mean, square
those deviations and then weight the squared deviations by the probability of
their occurrence. Add up the weighted and squared deviations from the mean
and you have found the variance!

Model (CAPM)
9 - 85
Measuring Variances, Standard Deviations of

the Forecast Market Returns
Now do this for the possible returns on the market

Model (CAPM)
9 - 86
Covariance
From Chapter 8 you know the formula for the covariance
between the returns on the stock and the returns on the
market is:
[8-12]
COV AB Prob i (k A,i ki )(k B ,i - k B )

i 1
Covariance is an absolute measure of the degree of comovement of returns.

Model (CAPM)
9 - 87
Correlation Coefficient
Correlation is covariance normalized by the product of the standard
deviations of both securities. It is a relative measure of co-movement of
returns on a scale from -1 to +1.
The formula for the correlation coefficient between the returns on the stock
and the returns on the market is:
[8-13]
AB
COV AB
A B
The correlation coefficient will always have a value in the range of +1 to

-1.
+1 is perfect positive correlation (there is no diversification potential when combining these two
securities together in a two-asset portfolio.)
- 1 - is perfect negative correlation (there should be a relative weighting mix of these two securities
in a two-asset portfolio that will eliminate all portfolio risk)

Model (CAPM)
9 - 88
Measuring Covariance
from Ex Ante Return Data
Using the expected return (mean return) and given data measure the
deviations for both the market and the stock and multiply them
together with the probability of occurrencethen add the products
up.

Model (CAPM)
9 - 89
The Beta Measured

Using Ex Ante Covariance (stock, market) and Market Variance
Now you can substitute the values for covariance and the
variance of the returns on the market to find the beta of
the stock:
Beta
Cov S, M
Var M
.01335
1.8
.007425
A beta that is greater than 1 means that the investment is aggressiveits

returns are more volatile than the market as a whole.
If the market returns were expected to go up by 10%, then the stock
returns are expected to rise by 18%. If the market returns are expected
to fall by 10%, then the stock returns are expected to fall by 18%.
Model (CAPM)
9 - 90
Lets Prove the Beta of the Market is 1.0

Let us assume we are comparing the possible market
returns against itselfwhat will the beta be?
Beta
Cov `M,M
Var M
.007425
1.0
.007425
Since
Sincethe
thevariance
varianceof
ofthe
thereturns
returnson
onthe
themarket
marketisis==.007425
.007425the
thebeta
betafor
for
the
market
is
indeed
equal
to
1.0
!!!
the market is indeed equal to 1.0 !!!

Model (CAPM)
9 - 91
Proving the Beta of Market = 1

If you now place the covariance of the market with itself
value in the beta formula you get:
Cov MM
.007425
Beta
1.0
Var(R M ) .007425
The beta coefficient of the market will always be

1.0 because you are measuring the market returns
against market returns.
Model (CAPM)
9 - 92
Using the Security Market Line

Expected versus Required Return
How Do We use Expected and Required Rates

of Return?
Once you have estimated the expected and required rates of return, you
can plot them on the SML and see if the stock is under or overpriced.
% Return
E(Rs) = 5.0%
R(ks) = 4.76%
SML
E(kM)= 4.2%
Risk-free Rate = 3%
BM= 1.0
Bs = 1.464
Since E(r)>R(r) the stock is underpriced.

Model (CAPM)
9 - 94
How Do We use Expected and Required Rates

of Return?
The stock is fairly priced if the expected return = the required return.
This is what we would expect to see normally or most of the time in an efficient
market where securities are properly priced.
% Return
E(Rs) = R(Rs) 4.76%
SML
E(RM)= 4.2%
Risk-free Rate = 3%
B M=
1.0
BS = 1.464

Model (CAPM)
9 - 95
Use of the Forecast Beta

We can use the forecast beta, together with an estimate of the
risk-free rate and the market premium for risk to calculate the
investors required return on the stock using the CAPM:
Required Return RF i [E (k M ) RF]

This is a market-determined return based on the current risk-free
rate (RF) as measured by the 91-day, government of Canada T-bill
yield, and a current estimate of the market premium for risk (k M
RF)
Model (CAPM)
9 - 96
Conclusions
Analysts can make estimates or forecasts for the
returns on stock and returns on the market portfolio.
Those forecasts can be analyzed to estimate the beta
coefficient for the stock.
The required return on a stock can then be calculated
using the CAPM but you will need the stocks beta
coefficient, the expected return on the market
portfolio and the risk-free rate.
The required return is then using in Dividend Discount
Models to estimate the intrinsic value (inherent
worth) of the stock.
Model (CAPM)
9 - 97
Calculating the Beta using Trailing

Holding Period Returns
APPENDIX 2
The Regression Approach to Measuring the

Beta
You need to gather historical data about the stock and the market
You can use annual data, monthly data, weekly data or daily data.
However, monthly holding period returns are most commonly used.
Daily data is too noisy (short-term random volatility)
Annual data will extend too far back in to time
You need at least thirty (30) observations of historical data.
Hopefully, the period over which you study the historical returns of the
stock is representative of the normal condition of the firm and its
relationship to the market.
If the firm has changed fundamentally since these data were produced
(for example, the firm may have merged with another firm or have
divested itself of a major subsidiary) there is good reason to believe
that future returns will not reflect the pastand this approach to beta
estimation SHOULD NOT be used.rather, use the ex ante approach.
Model (CAPM)
9 - 99
Historical Beta Estimation

The Approach Used to Create the Characteristic Line
In this example, we have regressed the quarterly returns on the stock against the
quarterly returns of a surrogate for the market (TSE 300 total return composite
index) and then using Excelused the charting feature to plot the historical
points and add a regression trend line.
The cloud of plotted points

represents diversifiable or company
specific risk in the securities returns
that can be eliminated from a portfolio
through diversification. Since
company-specific risk can be
eliminated, investors dont require
compensation for it according to
Markowitz Portfolio Theory.
The regression line is a line of best
fit that describes the inherent
relationship between the returns on
the stock and the returns on the
market. The slope is the beta
coefficient.

Model (CAPM)
9 - 100
Characteristic Line
The characteristic line is a regression line that represents the
relationship between the returns on the stock and the returns on
the market over a past period of time. (It will be used to forecast
the future, assuming the future will be similar to the past.)
The slope of the Characteristic Line is the Beta Coefficient.
The degree to which the characteristic line explains the variability
in the dependent variable (returns on the stock) is measured by
the coefficient of determination. (also known as the R2 (r-squared
or coefficient of determination)).
If the coefficient of determination equals 1.00, this would mean
that all of the points of observation would lie on the line. This
would mean that the characteristic line would explain 100% of the
variability of the dependent variable.
The alpha is the vertical intercept of the regression (characteristic
line). Many stock analysts search out stocks with high alphas.

Model (CAPM)
9 - 101
Low R2
An R2 that approaches 0.00 (or 0%) indicates that the
characteristic (regression) line explains virtually none of the
variability in the dependent variable.
This means that virtually of the risk of the security is
company-specific.
This also means that the regression model has virtually no
predictive ability.
In this case, you should use other approaches to value the
stockdo not use the estimated beta coefficient.
(See the following slide for an illustration of a low r-square)

Model (CAPM)
9 - 102
Characteristic Line for Imperial Tobacco

An Example of Volatility that is Primarily Company-Specific
Returns on
Imperial
Tobacco %
Characteristic
Line for Imperial
Tobacco
High alpha
High alpha
R-square is very
R-square is very
low
low0.02
0.02
Beta is largely
Beta is largely
irrelevant
irrelevant
Returns on
the Market %
(S&P TSX)

Model (CAPM)
9 - 103
High R2
An R2 that approaches 1.00 (or 100%) indicates that the
characteristic (regression) line explains virtually all of the
variability in the dependent variable.
This means that virtually of the risk of the security is
systematic.
This also means that the regression model has a strong
predictive ability. if you can predict what the market will
dothen you can predict the returns on the stock itself with
a great deal of accuracy.

Model (CAPM)
9 - 104
Characteristic Line General Motors

A Positive Beta with Predictive Power
Returns on
General
Motors %
Characteristic
Line for GM
(high R2)
Positive
Positivealpha
alpha
R-square
R-squareisis
very
veryhigh
high0.9
0.9
Beta
Betaisispositive
positive
and
close
and closeto
to1.0
1.0
Returns on
the Market %
(S&P TSX)

Model (CAPM)
9 - 105
An Unusual Characteristic Line

A Negative Beta with Predictive Power
Returns on a
Stock %
Characteristic Line for a stock

that will provide excellent
portfolio diversification
Positive
Positivealpha
alpha
(high R2)
R-square
R-squareisis
very
veryhigh
high
Beta
Betaisisnegative
negative
<0.0
and
<0.0 and>>-1.0
-1.0
Returns on
the Market %
(S&P TSX)

Model (CAPM)
9 - 106
Diversifiable Risk
(Non-systematic Risk)
Volatility in a securitys returns caused by companyspecific factors (both positive and negative) such as:
a single company strike

a spectacular innovation discovered through the companys R&D program
equipment failure for that one company
management competence or management incompetence for that
particular firm
a jet carrying the senior management team of the firm crashes (this could
be either a positive or negative event, depending on the competence of
the management team)
the patented formula for a new drug discovered by the firm.
Obviously, diversifiable risk is that unique factor that

influences only the one firm.

Model (CAPM)
9 - 107
OK lets go back and look at raw data

gathering and data normalization
A common source for stock of information is Yahoo.com
You will also need to go to the library a use the TSX Review
(a monthly periodical) to obtain:
Number of shares outstanding for the firm each month
Ending values for the total return composite index (surrogate for the
market)
You want data for at least 30 months.

For each month you will need:
Ending stock price

Number of shares outstanding for the stock
Dividend per share paid during the month for the stock
Ending value of the market indicator series you plan to use (ie. TSE
300 total return composite index)
Model (CAPM)
9 - 108
Demonstration Through Example

The following slides will be based on
Alcan Aluminum (AL.TO)
Five Year Stock Price Chart for AL.TO

Model (CAPM)
9 - 110
Spreadsheet Data From Yahoo

Process:
Go to http://ca.finance.yahoo.com
Use the symbol lookup function to search for the
company you are interested in studying.
Use the historical quotes buttonand get 30 months
of historical data.
Use the download in spreadsheet format feature to
save the data to your hard drive.

Model (CAPM)
9 - 111

Alcan Example
The raw downloaded data should look like this:

Model (CAPM)
9 - 112

Alcan Example
The raw downloaded data should look like this:
The
Theday,
day,
month
monthand
and
year
year
Opening
Openingprice
priceper
pershare,
share,the
the
highest
highestprice
priceper
pershare
shareduring
duringthe
the
month,
month,the
thelowest
lowestprice
priceper
pershare
share
achieved
achievedduring
duringthe
themonth
monthand
andthe
the
closing
closingprice
priceper
pershare
shareatatthe
theend
end
ofofthe
CHAPTER
9 The Capital Asset Pricing
themonth
month
Model (CAPM)
Volume
Volumeofof
trading
tradingdone
done
ininthe
thestock
stockon
on
the
theTSE
TSEininthe
the
month
monthinin
numbers
numbersofof
board
9 -lots
113
board
lots

Alcan Example
From Yahoo, the only information you can use is the

closing price per share and the date. Just delete the
other columns.

Model (CAPM)
9 - 114
Acquiring the Additional Information You Need

Alcan Example
In addition to the closing price of the stock on a per share

basis, you will need to find out how many shares were
outstanding at the end of the month and whether any
dividends were paid during the month.
You will also want to find the end-of-the-month value of the
S&P/TSX Total Return Composite Index (look in the green
pages of the TSX Review)
You can find all of this in The TSX Review periodical.

Model (CAPM)
9 - 115
Raw Company Data

Alcan Example
Number of shares doubled and share price fell by half between

January and February 2002 this is indicative of a 2 for 1 stock split.
Model (CAPM)
9 - 116
Normalizing the Raw Company Data

Alcan Example
The adjustment factor is just the value in the issued

capital cell divided by 321,400,589.

Model (CAPM)
9 - 117
Calculating the HPR on the stock from the

Normalized Data
HPR
( P1 P0 ) D1
P0
$59.22 - $57.90 $0.00

$57.90
2.28%
Use $59.22 as the ending price, $57.90 as the

beginning price and during the month of May, no
dividend was declared.
Model (CAPM)
9 - 118
Now Put the data from the S&P/TSX Total

Return Composite Index in
You
Youwill
willfind
findthe
theTotal
TotalReturn
ReturnS&P/TSX
S&P/TSXComposite
Composite
Index
Indexvalues
valuesininTSX
TSXReview
Reviewfound
foundininthe
thelibrary.
library.
Model (CAPM)
9 - 119
Now Calculate the HPR on the Market Index

HPR
( P1 P0 )
P0
16,911.33 - 16,903.36
16,903.36
0.05%
Again,
Again,you
yousimply
simplyuse
usethe
theHPR
HPRformula
formulausing
usingthe
the
ending
endingvalues
valuesfor
forthe
thetotal
totalreturn
returncomposite
compositeindex.
index.
Model (CAPM)
9 - 120
Regression In Excel
If you havent alreadygo to the tools

menudown to add-ins and check off the VBA
Analysis Pac
When you go back to the tools menu, you
should now find the Data Analysis bar, under
that find regression, define your dependent
and independent variable ranges, your output
range and run the regression.
Model (CAPM)
9 - 121
Regression
Defining the Data Ranges
The
independent
variable
variable
isisisthe
the
returns
returns
on
on
the
the
Stock.
Market.
Thedependent
independent
dependent
variable
variable
isthe
the
returns
returns
on
on
the
the
Stock.
Market.
Model (CAPM)
9 - 122
Now Use the Regression Function in Excel to

regress the returns of the stock against the
returns of the market
R-square is the
coefficient of
determination =
0.0028=.3%
Beta
Coefficient
is the XVariable 1
The alpha is the

vertical intercept.

Model (CAPM)
9 - 123
Finalize Your Chart

Alcan Example
You can use the charting feature in Excel to create a

scatter plot of the points and to put a line of best fit
(the characteristic line) through the points.
In Excel, you can edit the chart after it is created by
placing the cursor over the chart and right-clicking
your mouse.
In this edit mode, you can ask it to add a trendline
(regression line)
Finally, you will want to interpret the Beta (Xcoefficient) the alpha (vertical intercept) and the
coefficient of determination.
Model (CAPM)
9 - 124
The Beta
Alcan Example
Obviously the beta (X-coefficient) can simply

be read from the regression output.
In this case it was 3.56 making Alcans returns more
than 3 times as volatile as the market as a whole.
Of course, in this simple example with only 5
observations, you wouldnt want to draw any serious
conclusions from this estimate.

Model (CAPM)
9 - 125
Copyright
Copyright 2007 John Wiley & Sons
Canada, Ltd. All rights reserved.
Reproduction or translation of this
work beyond that permitted by
Access Copyright (the Canadian
copyright licensing agency) is
unlawful. Requests for further
information should be addressed to
the Permissions Department, John
Wiley & Sons Canada, Ltd. The
purchaser may make back-up copies
for his or her own use only and not
for distribution or resale. The author
and the publisher assume no
responsibility for errors, omissions,
or damages caused by the use of
these files or programs or from the
use of the information contained
herein.

Model (CAPM)
9 - 126

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INTRODUCTION TO

Chapter 9 The Capital Asset Pricing

Concept Review Questions

CHAPTER 9 The Capital Asset Pricing

Important Chapter Terms

Market risk premium

CHAPTER 9 The Capital Asset Pricing

Achievable Portfolio Combinations

Achievable Portfolio Combinations

It is possible to construct a series of portfolios with

The following table shows the portfolio characteristics for 100

Example of Portfolio Combinations and

CHAPTER 9 The Capital Asset Pricing

Example of Portfolio Combinations and

CHAPTER 9 The Capital Asset Pricing

Two Asset Efficient Frontier

(See Figure 8 -10 on the following slide)

CHAPTER 9 The Capital Asset Pricing

efficient frontier and

CHAPTER 9 The Capital Asset Pricing

attainable but are

Achievable Set of Portfolio Combinations

In a real world investment universe with all of the

The Achievable Set of Portfolio

CHAPTER 9 The Capital Asset Pricing

Achievable Portfolio Combinations

Portfolio Risk (p)

CHAPTER 9 The Capital Asset Pricing

The Achievable Set of Portfolio

CHAPTER 9 The Capital Asset Pricing

Achievable Portfolio Combinations

Portfolio Risk (p)

CHAPTER 9 The Capital Asset Pricing

Achievable Set of Portfolio Combinations

When you construct many hundreds of

CHAPTER 9 The Capital Asset Pricing

Achievable Portfolio Combinations

Portfolio Risk (p)

CHAPTER 9 The Capital Asset Pricing

The Efficient Frontier

Achievable Portfolio Combinations

Portfolio Risk (p)

CHAPTER 9 The Capital Asset Pricing

The New Efficient Frontier

CHAPTER 9 The Capital Asset Pricing

We assume investors are risk-averse wealth

A risk-averse investor prefers the risk-free situation.

The implication of this, is that investors will only choose

The New Efficient Frontier and

CHAPTER 9 The Capital Asset Pricing

The New Efficient Frontier

Expected return on a two asset portfolio made up of

CHAPTER 9 The Capital Asset Pricing

The New Efficient Frontier

CHAPTER 9 The Capital Asset Pricing

The New Efficient Frontier

CHAPTER 9 The Capital Asset Pricing

The New Efficient Frontier

CHAPTER 9 The Capital Asset Pricing

The New Efficient Frontier

CHAPTER 9 The Capital Asset Pricing

The New Efficient Frontier

Lending Portfolios Borrowing Portfolios

The line can be