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FINM7007 Applied Corporate Finance Lecture 4Capital Asset Pricing Model (CAPM)
BD Chapter 11.4-11.8, 12.1-12.3
11.4 Risk VS Return: Choosing an Efficient Portfolio
- Efficient Portfolios with Two Stocks
- Identifying Inefficient Portfolios
o In an inefficient portfolio, it is possible to find another portfolio
that is better in terms of both expected return and volatility.
- Identifying Efficient Portfolios
o Recall from Chapter 10, in an efficient portfolio there is no way to
reduce the volatility of the portfolio without lowering its expected
return.
- Consider a portfolio of Intel and Coca-Cola

Table 11.4 Expected Returns and Volatility for Different Portfolios of Two Stocks



Figure 11.3 Volatility Versus Expected Return for Portfolios of Intel and Coca-Cola
Stock


- Consider investing 100% in Coca-Cola stock. As shown in on the
previous slide, other portfoliossuch as the portfolio with 20% in Intel

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FINM7007 Applied Corporate Finance Lecture 4Capital Asset Pricing Model (CAPM)
BD Chapter 11.4-11.8, 12.1-12.3
stock and 80% in Coca-Cola stockmake the investor better off in two
ways: It has a higher expected return, and it has lower volatility. As a
result, investing solely in Coca-Cola stock is inefficient.

The Effect of Correlation

- Correlation has no effect on the expected return of a portfolio. However, the
volatility of the portfolio will differ depending on the correlation.
- The LOWER the correlation, the LOWER the volatility we can obtain. As the
correlation decreases, the volatility of the portfolio falls.
- The curve showing the portfolios will bend to the left to a greater degree as
shown on the next slide.

Figure 11.4 Effect on Volatility and Expected Return of Changing the Correlation
between Intel and Coca-Cola Stock



Short Sales
- Long Position
- A positive investment in a security
- Short Position
- A negative investment in a security
- In a short sale, you sell a stock that you do NOT own and
then buy that stock back in the future.
- Short selling is an advantageous strategy if you expect a
stock price to decline in the future.



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FINM7007 Applied Corporate Finance Lecture 4Capital Asset Pricing Model (CAPM)
BD Chapter 11.4-11.8, 12.1-12.3
Figure 11.5 Portfolios of Intel and Coca-Cola Allowing for Short Sales


Efficient Portfolios with Many Stocks

- Consider adding Bore Industries to the two stock portfolio:

o Although Bore has a lower return and the same volatility as Coca-Cola, it
still may be beneficial to add Bore to the portfolio for the diversification
benefits.

Figure 11.6 Expected Return and Volatility for Selected Portfolios of Intel, Coca-
Cola, and Bore Industries Stocks


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FINM7007 Applied Corporate Finance Lecture 4Capital Asset Pricing Model (CAPM)
BD Chapter 11.4-11.8, 12.1-12.3
Figure 11.7 The Volatility and Expected Return for All Portfolios of Intel, Coca-Cola,
and Bore Stock


Risk Versus Return: Many Stocks

- The efficient portfolios, those offering the HIGHEST possible expected return
for a given level of volatility, are those on the northwest edge of the shaded
region, which is called the efficient frontier for these three stocks.
- In this case none of the stocks, on its own, is on the efficient frontier, so it
would NOT be efficient to put all our money in a SINGLE STOCK.

Figure 11.8 Efficient Frontier with Ten Stocks Versus Three


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FINM7007 Applied Corporate Finance Lecture 4Capital Asset Pricing Model (CAPM)
BD Chapter 11.4-11.8, 12.1-12.3
Stocks Risk-Free Saving and Borrowing
- Risk can also be REDUCED by investing a portion of a portfolio in a
risk-free investment, like T-Bills. However, doing so will likely reduce
the expected return.
- On the other hand, an aggressive investor who is seeking high
expected returns might decide to borrow money to invest even more
in the stock market.

Figure 11.9 The RiskReturn Combinations from Combining a Risk-Free Investment
and a Risky Portfolio

Borrowing and Buying Stocks on Margin
- Buying Stocks on Margin
- Borrowing money to invest in a stock.
- A portfolio that consists of a short position in the risk-free investment is
known as a levered portfolio. Margin investing is a risky investment
strategy.

Identifying the Tangent Portfolio
- To earn the HIGHEST possible expected return for any level of volatility we
must find the portfolio that generates the STEEPEST possible line when
combined with the risk-free investment.

- Sharpe Ratio

- Measures the ratio of reward-to-volatility provided by a portfolio


[ ]
Portfolio Excess Return
Sharpe Ratio
Portfolio Volatility ( )

= =
P f
P
E R r
SD R

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FINM7007 Applied Corporate Finance Lecture 4Capital Asset Pricing Model (CAPM)
BD Chapter 11.4-11.8, 12.1-12.3
o The portfolio with the HIGHEST Sharpe ratio is the portfolio where the line
with the risk-free investment is tangent to the efficient frontier of risky
investments. The portfolio that generates this tangent line is known as
the tangent portfolio.

Figure 11.10 The Tangent or Efficient Portfolio


- Combinations of the risk-free asset and the tangent portfolio provide the best risk
and return tradeoff available to an investor.
- This means that the tangent portfolio is efficient and that all efficient portfolios
are combinations of the risk-free investment and the tangent portfolio. Every
investor should invest in the tangent portfolio independent of his or her
taste for risk.

- An investors preferences will determine only how much to invest in the
tangent portfolio versus the risk-free investment.
- Conservative investors will invest a small amount in the tangent portfolio.
- Aggressive investors will invest more in the tangent portfolio.
- Both types of investors will choose to hold the same portfolio of risky
assets, the tangent portfolio, which is the efficient portfolio.

Expected Returns and the Efficient Portfolio

- Expected Return of a Security

- A portfolio is efficient if and only if the expected return of every available
security equals its required return.


[ ] ( [ ] ) = +
eff
i i f i eff f
E R r r E R r |

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FINM7007 Applied Corporate Finance Lecture 4Capital Asset Pricing Model (CAPM)
BD Chapter 11.4-11.8, 12.1-12.3
11.7 The Capital Asset Pricing Model (CAPM)

- The Capital Asset Pricing Model (CAPM) allows us to identify the efficient
portfolio of risky assets without having any knowledge of the expected
return of each security.
- Instead, the CAPM uses the optimal choices investors make to identify the
efficient portfolio as the market portfolio, the portfolio of all stocks and
securities in the market.

The CAPM Assumptions

- 3 Main Assumptions
- Assumption 1
Investors can buy and sell all securities at competitive market prices
(without incurring taxes or transactions costs) and can borrow and lend
at the risk-free interest rate.

- Assumption 2
Investors hold only efficient portfolios of traded securitiesportfolios
that yield the maximum expected return for a given level of volatility.

- Assumption 3
Investors have homogeneous expectations regarding the volatilities,
correlations, and expected returns of securities.
Homogeneous Expectations
- All investors have the same estimates concerning future investments
and returns.

Supply, Demand, and the Efficiency of the Market Portfolio

- Given homogeneous expectations, all investors will DEMAND the SAME
efficient portfolio of risky securities.
- The combined portfolio of risky securities of all investors must equal the
efficient portfolio.
- Thus, if all investors DEMAND the efficient portfolio, and the SUPPLY of
securities is the market portfolio, the DEMAND for market portfolio must
EQUAL the SUPPLY of the market portfolio.

Example

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FINM7007 Applied Corporate Finance Lecture 4Capital Asset Pricing Model (CAPM)
BD Chapter 11.4-11.8, 12.1-12.3


Optimal Investing: The Capital Market Line

- When the CAPM assumptions hold, an optimal portfolio is a combination of
the risk-free investment and the market portfolio.
- When the tangent line goes through the market portfolio, it is called the capital
market line (CML).
- The expected return and volatility of a capital market line portfolio are:




Figure 11.11 The Capital Market Line

[ ] (1 ) [ ] ( [ ] ) = + = +
xCML f Mkt f Mkt f
E R x r xE R r x E R r
( ) ( ) =
xCML Mkt
SD R xSD R

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FINM7007 Applied Corporate Finance Lecture 4Capital Asset Pricing Model (CAPM)
BD Chapter 11.4-11.8, 12.1-12.3
Determining the Risk Premium

- Market Risk and Beta

- Given an efficient market portfolio, the expected return of an investment
is:


- The beta is defined as:



Example

Problem
- Assume the risk-free return is 5% and the market portfolio has an expected
return of 12% and a standard deviation of 44%.
- ATP Oil and Gas has a standard deviation of 68% and a correlation with the
market of 0.91.
- What is ATPs beta with the market?
- Under the CAPM assumptions, what is its expected return?

Solution





The Security Market Line

- There is a linear relationship between a stocks beta and its expected return
(See figure on next slide). The security market line (SML) is graphed as the line
through the risk-free investment and the market.
- According to the CAPM, if the expected return and beta for individual
securities are plotted, they should all fall along the SML.
Risk premium for security
[ ] ( [ ] ) = = +
Mkt
i i f i Mkt f
i
E R r r E R r |
Volatility of that is common with the market
i
( ) ( , ) ( , )

( ) ( )

= =
i
Mkt i i Mkt i Mkt
i
Mkt Mkt
SD R Corr R R Cov R R
SD R Var R
| |
i
( ) ( , ) (.68)(.91)
1.41
( ) .44

= = =
i i Mkt
Mkt
SD R Corr R R
SD R
|
[ ] ( [ ] ) 5% 1.41(12% 5%) 14.87% = + = + =
Mkt
i f i Mkt f
E R r E R r |

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FINM7007 Applied Corporate Finance Lecture 4Capital Asset Pricing Model (CAPM)
BD Chapter 11.4-11.8, 12.1-12.3
Figure 11.12 The Capital Market Line and the Security Market Line


Figure 11.12 The Capital Market Line and the Security Market Line, panel (a)



(a) The CML depicts portfolios combining the risk-free investment and the
efficient portfolio, and shows the HIGHEST expected return that we can
attain for each level of volatility. According to the CAPM, the market
portfolio is on the CML and all other stocks and portfolios contain
diversifiable risk and lie to the right of the CML, as illustrated for Exxon Mobil
(XOM).



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FINM7007 Applied Corporate Finance Lecture 4Capital Asset Pricing Model (CAPM)
BD Chapter 11.4-11.8, 12.1-12.3
Figure 11.12 The Capital Market Line and the Security Market Line, panel (b)

(b) The SML shows the expected return for each security as a function of its
beta with the market. According to the CAPM, the market portfolio is
efficient, so all stocks and portfolios should lie on the SML.

- Beta of a Portfolio

The beta of a portfolio is the weighted average beta of the securities in the
portfolio.

Example
( )
,
( , ) ( , )

( ) ( ) ( )
= = = =

i i Mkt
i
P Mkt i Mkt
P i i i
i i
Mkt Mkt Mkt
Cov x R R
Cov R R Cov R R
x x
Var R Var R Var R
| |

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FINM7007 Applied Corporate Finance Lecture 4Capital Asset Pricing Model (CAPM)
BD Chapter 11.4-11.8, 12.1-12.3

Alpha (cont'd)

- When the market portfolio is EFFICIENT, all stocks are on the security
market line and have an ALPHA of ZERO.
- Investors can improve the performance of their portfolios by BUYING
stocks with POSITIVE alphas and by SELLING stocks with
NEGATIVE alphas.
Figure An Inefficient Market Portfolio


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FINM7007 Applied Corporate Finance Lecture 4Capital Asset Pricing Model (CAPM)
BD Chapter 11.4-11.8, 12.1-12.3
Figure Deviations from the Security Market Line


Summary of the Capital Asset Pricing Model
- The market portfolio is the efficient portfolio.
- The risk premium for any security is proportional to its beta with the market.
Determining Beta
- Estimating Beta from Historical Returns
- Recall, beta is the expected percent change in the excess return of the
security for a 1% change in the excess return of the market portfolio.
- Consider Cisco Systems stock and how it changes with the market portfolio.
Monthly Returns for Cisco Stock and for the S&P 500, 19962005


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FINM7007 Applied Corporate Finance Lecture 4Capital Asset Pricing Model (CAPM)
BD Chapter 11.4-11.8, 12.1-12.3
Scatterplot of Monthly Excess Returns for Cisco Versus the S&P 500, 19962005


- Estimating Beta from Historical Returns
- As the scatterplot on the previous slide shows, Cisco tends to be up when the
market is up, and vice versa.
- We can see that a 10% change in the markets return corresponds to about a
20% change in Ciscos return.
o Thus, Ciscos return moves about two for one with the overall market, so
Ciscos beta is about 2.
- Beta corresponds to the slope of the best-fitting line in the plot of the
securitys excess returns versus the market excess return.

Using Linear Regression
- Linear Regression
- The statistical technique that identifies the best-fitting line through a set of
points.


o
i
is the intercept term of the regression.
o
i
(R
Mkt
r
f
) represents the sensitivity of the stock to market risk.
o
i
is the error term and represents the deviation from the best-fitting line and
is zero on average.
o
- Since E[
i
] = 0:

o
i
represents a risk-adjusted performance measure for the historical returns.
If
i
is POSITIVE, the stock has performed better than predicted by
the CAPM.
If
i
is NEGATIVE, the stocks historical return is below the SML.
( ) ( ) = + +
i f i i Mkt f i
R r R r o | c
Distance above / below the SML
Expected return for from the SML
[ ] ( [ ] ) = + +
i f i Mkt f i
i
E R r E R r | o

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FINM7007 Applied Corporate Finance Lecture 4Capital Asset Pricing Model (CAPM)
BD Chapter 11.4-11.8, 12.1-12.3
- Given data for r
f
, R
i
, and R
Mkt
, statistical packages for linear regression can
estimate
i
.
o A regression for Cisco using the monthly returns for 19962004 indicates
the estimated beta is 1.94.
o The estimate of Ciscos alpha from the regression is 1.2%.

Investor Information and Rational Expectations
- In the CAPM framework, investors should hold the market portfolio combined
with risk-free investments
This investment advice does NOT depend on the quality of an investors
information.
- Rational Expectations
Investors may have different information regarding expected returns,
correlations, and volatilities, but they correctly interpret that information
and the information contained in market prices and adjust their estimates of
expected returns in a rational way.
Example


- Regardless of how much information an investor has access to, he can
guarantee himself an alpha of ZERO by holding the market portfolio.
- Because the average portfolio of all investors is the market portfolio, the
average alpha of all investors is ZERO.
- If no investor earns a negative alpha, then no investor can earn a positive
alpha, and the market portfolio must be efficient.
- The market portfolio can be inefficient only if a significant number of investors
either:

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FINM7007 Applied Corporate Finance Lecture 4Capital Asset Pricing Model (CAPM)
BD Chapter 11.4-11.8, 12.1-12.3
- Misinterpret information and believe they are earning a positive alpha when
they are actually earning a negative alpha, or
- Care about aspects of their portfolios other than expected return and
volatility, and so are willing to hold inefficient portfolios of securities.

The CAPM in Practice

- Forecasting Beta

- Time Horizon
o For stocks, common practice is to use at least two years of weekly return
data or five years of monthly return data.
- The Market Proxy
o In practice the S&P 500 is used as the market proxy.
Other proxies include the NYSE Composite Index and the Wilshire 5000.
- Beta Extrapolation
o Many practitioners prefer to use average industry betas rather than individual
stock betas.
o In addition, evidence suggests that betas tend to regress toward the average
beta of 1.0 over time.
- Outliers
o The beta estimates obtained from linear regression can be very sensitive to
outliers.


Beta Estimation with and without Outliers for Genentech Using Monthly Returns for
20022004

- Other Considerations
o Historical betas may not be a good measure if a firm were to change
industries.


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FINM7007 Applied Corporate Finance Lecture 4Capital Asset Pricing Model (CAPM)
BD Chapter 11.4-11.8, 12.1-12.3
Evidence Regarding the CAPM
- Historically, researchers have found that expected returns were related to
betas, as predicted by the CAPM, rather than to other measures of risk
such as the securitys volatility.
- However, they did find the empirically estimated security market line is
somewhat flatter than that predicted by the CAPM, as shown on the next
slide.
Empirical SML Versus SML Predicted by CAPM (Black, Jensen, and Scholes, 1972)

- More recently, researchers have found problems with the CAPM:
- Betas are not observed.
o If betas change over time, evidence against the CAPM may be the result
of mismeasuring betas.
- Expected returns are not observed.
o Even if beta is a perfect measure of risk, average returns need not match
expected returns. The realized average return need not match
investors expectations.
- The market proxy is not correct.
o Although the S&P 500 is a reasonable proxy for the U.S. stock market,
investors hold many other assets. For example, the U.S. stock market
represents only about 50% of world equity markets.
o Any failure of the CAPM may simply be the result of our failure to find a
good measure of the market portfolio.

The Bottom Line on the CAPM
- The CAPM remains the predominant model used in practice to determine the
equity cost of capital.
- Although the CAPM is NOT perfect, it is unlikely that a truly perfect model
will be found in the foreseeable future.
o The imperfections of the CAPM may NOT be critical in the context of capital
budgeting.
Errors in estimating project cash flows are likely to be far more
important than small discrepancies in the cost of capital.