The Capital Asset Pricing Model CAPM The CAPM

The Capital Market Line • The capital market line – adds a risk-free return

The Capital Market Line Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Risk and Return • The investor continues to select the portfolio that – offers

Risk and Return • Different asset classes lie on the capital market line Copyright

Beta Coefficients • An index of risk • Measures the volatility of a stock

Beta Coefficients Combine • The variability of the asset’s return • The variability of

Beta Coefficients • Beta coefficients are the slope of the regression line relating –

Beta Coefficients Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Interpretation of the Numerical Value of Beta • Beta = 1. 0 Stock's return

Interpretation of the Numerical Value of Beta Copyright © 2003 South-Western/Thomson Learning. All rights

High Beta Stocks • More systematic market risk • May be appropriate for high-risk

Low Beta Stocks • Less systematic market risk • May be appropriate for low-risk

Individual Stock Betas • May change over time • Tendency to move toward 1.

Portfolio Betas • Weighted average of the individual asset's betas • May be more

Beta Coefficients and The Security Market Line • The return on a stock depends

Beta Coefficients and The Security Market Line • The figure relating systematic risk (beta)

Beta Coefficients and The Security Market Line Copyright © 2003 South-Western/Thomson Learning. All rights

Arbitrage Pricing Theory (APT) • In the CAPM – a stock's return depends only

Arbitrage • Buying in one market and simultaneously selling in another market to take

APT explains security returns in terms of • The expected return • A series

Common Factors • Unexpected inflation • Unexpected changes in industrial production • Unanticipated shifts

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The Capital Asset Pricing Model (CAPM) • The CAPM has – A macro component explains risk and return in a portfolio context – A micro component explains individual stock returns – The micro component is also used to value stocks Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Risk and Return • The investor continues to select the portfolio that – offers the highest return for a given level of risk – maximizes satisfaction • Different investors may select different combinations of risk and return Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Beta Coefficients Combine • The variability of the asset’s return • The variability of the market return • The correlation between – the stock's return and – the market return Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Beta Coefficients • Beta coefficients are the slope of the regression line relating – the return on the market (the independent variable) to – the return on the stock (the dependent variable) Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Interpretation of the Numerical Value of Beta • Beta = 1. 0 Stock's return has same volatility as the market return • Beta > 1. 0 Stock's return is more volatile than the market return Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Beta Coefficients and The Security Market Line • The return on a stock depends on – the risk free rate (rf) – the return on the market (rm) – the stock's beta – the return on a stock: k= rf + (rm - rf)beta Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Arbitrage Pricing Theory (APT) • In the CAPM – a stock's return depends only on • the market return • the volatility of the stock (the beta) • APT is an alternative to the Capital Asset Pricing Model Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Arbitrage • Buying in one market and simultaneously selling in another market to take advantage of price differentials • Assures there can be only one price • Assures that portfolios with the same risk will have the same returns Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

APT explains security returns in terms of • The expected return • A series of factors that may affect security prices • How the individual stock responds to unanticipated changes in those factors Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Common Factors • Unexpected inflation • Unexpected changes in industrial production • Unanticipated shifts in risk premiums • Unanticipated changes in the structure of yields Copyright © 2003 South-Western/Thomson Learning. All rights reserved.