CHAPTER 9 The Capital Asset Pricing Model Investments

CHAPTER 9 The Capital Asset Pricing Model Investments, 8 th edition Bodie, Kane and Marcus Slides by Susan Hine Mc. Graw-Hill/Irwin Copyright © 2009 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Capital Asset Pricing Model (CAPM) • It gives a precise prediction of the relationship that should be observed between the risk of an asset and its expected return. • Beneftis: – Provides benchmark rate of return for evaluating possible investments – Helps to make an educated guess as to the expected return on assets that have not yet been traded in the marketplace • It is the equilibrium model • Derived using principles of diversification with simplified assumptions • Markowitz, Sharpe, Lintner and Mossin 9 -2

Assumptions • Individual investors are price takers: they act as though security prices are unaffected by their own trades (their wealth is small compared to the total wealth of all investors) • Single-period investment horizon: myopicshort-sighted behavior (ignores everything that might happen after the end of the single period horizon) • Investments are limited to traded financial assets: (traded financial assets –bonds and stocks) and risk-free borrowing or lending) 9 -3

Assumptions Continued • No taxes and transaction costs • Information is costless and available to all investors • Investors are rational mean-variance optimizers: all investors use Markowitz Portfolio Selection Model (minimum-variance frontier, efficient frontier, CAL, optimal risky portfolio and optimal complete portfolio) • There are homogeneous expectations: all investors analyze securities in the same way and share the same economic view 9 -4

Resulting Equilibrium Conditions • All investors will hold the same portfolio for risky assets – market portfolio • Market portfolio contains all securities (all traded assets) and the proportion of each security is its market value as a percentage of total market value • Market portfolio: – on the efficient frontier – The tangency portfolio to the optimal CAL 9 -5

Figure 9. 1 The Efficient Frontier and the Capital Market Line 9 -6

Resulting Equilibrium Conditions Continued • Risk premium on the market depends on the average risk aversion of all market participants • Risk premium on an individual security is a function of its covariance with the market 9 -7

Market Risk Premium • The risk premium on the market portfolio will be proportional to its risk and the degree of risk aversion of the investor: X 0. 01 9 -8

Return and Risk For Individual Securities • The risk premium on individual securities is a function of the individual security’s contribution to the risk of the market portfolio • An individual security’s risk premium is a function of the covariance of returns with the assets that make up the market portfolio 9 -9

Using GE Text Example • Covariance of GE return with the market portfolio: • Therefore, the reward-to-risk ratio for investments in GE would be: 9 -10

Using GE Text Example Continued • Reward-to-risk ratio for investment in market portfolio: • Reward-to-risk ratios of GE and the market Basic portfolio: • And the risk premium for GE: Principle: all investments should offer the same reward-to-risk raito. Otherwise investors will rearrange their portfolios. 9 -11

Expected Return-Beta Relationship • CAPM holds for the overall portfolio because: • This also holds for the market portfolio: 9 -12

Figure 9. 2 The Security Market Line 9 -13

Figure 9. 3 The SML and a Positive-Alpha Stock Alpha: the difference between the fair and the actual expected rates of return 9 -14

The CAPM and Reality • Is the condition of zero alphas for all stocks as implied by the CAPM met – Not perfect but one of the best available • Is the CAPM testable – Proxies must be used for the market portfolio • CAPM is still considered the best available description of security pricing and is widely accepted 9 -15

Extensions of the CAPM • Zero-Beta Model – Helps to explain positive alphas on low beta stocks and negative alphas on high beta stocks • Consideration of labor income and nontraded assets • Merton’s Multiperiod Model and hedge portfolios – Incorporation of the effects of changes in the real rate of interest and inflation 9 -16

Extensions of the CAPM Continued • A consumption-based CAPM – Models by Rubinstein, Lucas, and Breeden • Investor must allocate current wealth between today’s consumption and investment for the future 9 -17

Liquidity and the CAPM • Liquidity • Illiquidity Premium • Research supports a premium for illiquidity. – Amihud and Mendelson – Acharya and Pedersen 9 -18

Figure 9. 5 The Relationship Between Illiquidity and Average Returns 9 -19

Three Elements of Liquidity • Sensitivity of security’s illiquidity to market illiquidity: • Sensitivity of stock’s return to market illiquidity: • Sensitivity of the security illiquidity to the market rate of return: 9 -20