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 Capital Market Theory:
An Overview
‡ Capital market theory extends portfolio
theory and develops a model for pricing all
risky assets
‡ Capital asset pricing model (CAPM) will
allow you to determine the required rate of
return for any risky asset
 Assumptions of
Capital Market Theory
1. All investors are Markowitz efficient
investors who want to target points on the
efficient frontier.
± The exact location on the efficient frontier and,
therefore, the specific portfolio selected, will
depend on the individual investor¶s risk-return
utility function.
 Assumptions of
Capital Market Theory
2. Investors can borrow or lend any amount of
money at the risk-free rate of return (RFR).
± Clearly it is always possible to lend money at
the nominal risk-free rate by buying risk-free
securities such as government T-bills. It is not
always possible to borrow at this risk-free rate,
but we will see that assuming a higher
borrowing rate does not change the general
results.
 Assumptions of
Capital Market Theory
3. All investors have homogeneous
expectations; that is, they estimate identical
probability distributions for future rates of
return.
± Again, this assumption can be relaxed. As long
as the differences in expectations are not vast,
their effects are minor.
 Assumptions of
Capital Market Theory
4. All investors have the same one-period
time horizon such as one-month, six
months, or one year.
± The model will be developed for a single
hypothetical period, and its results could be
affected by a different assumption. A
difference in the time horizon would require
investors to derive risk measures and risk-free
assets that are consistent with their time
horizons.
 Assumptions of
Capital Market Theory
5. All investments are infinitely divisible.
6. There are no taxes or transaction costs
involved in buying or selling assets.
7. There is no inflation or any change in
interest rates, or inflation is fully
anticipated.
8. Capital markets are in equilibrium.
 Assumptions of
Capital Market Theory
‡ Some of these assumptions are unrealistic
‡ Relaxing many of these assumptions would
have only minor influence on the model and
would not change its main implications or
conclusions.
‡ A theory should be judged on how well it
explains and helps predict behavior, not on
its assumptions.
 Risk-Free Asset
‡ An asset with zero standard deviation
‡ Zero correlation with all other risky assets
‡ Provides the risk-free rate of return (RFR)
‡ Will lie on the vertical axis of a portfolio
graph
 Risk-Free Asset
Covariance between two sets of returns is
n
Cov i A [R
i
i - E R i ][R - E R ]/n
            

X´ Ô  !

  "  
        

  #    "$ i%  
  
        
 
$ 
 Combining a Risk-Free Asset
with a Risky Portfolio
xpected return
the weighted average of the two returns
R port RF RFR â - RF Ri

Ô    #

 Combining a Risk-Free Asset
with a Risky Portfolio
Standard deviation
The expected variance for a two-asset portfolio is
 port
w  w ww r 
i
&      i  '  
  i  ( % 
 %

   
 


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Ô
 Ô
i    
        
$    
      
 $  )  %
D
 
 
 D  ÔD
 Combining a Risk-Free Asset
with a Risky Portfolio
D
Given the variance formula  ort
 w RF  D  ÔD
  
   
 
 D  ÔD

 Ô
Ô    
  #   
 %
         
  # #     
    
 #   
Combining a Risk-Free Asset
with a Risky Portfolio
Since both the expected return ÷
the
standard deviation of return for such a
portfolio are linear combinations, a graph of
possible portfolio returns and risks looks
like a straight line between the two assets.
Portfolio Possibilities Combining the Risk-Free Asset
and Risky Portfolios on the fficient Frontier

R ort *
+'

.
,


 -

 ort
Risk-Return Possibilities with Leverage
To attain a higher expected return than is
available at point M (in exchange for
accepting higher risk)
‡ ither invest along the efficient frontier
beyond point M, such as point D
‡ Or, add leverage to the portfolio by
borrowing money at the risk-free rate and
investing in the risky portfolio at point M
Portfolio Possibilities Combining the Risk-Free Asset
and Risky Portfolios on the fficient Frontier

R ort

*
+(
,



 ort
 The Market Portfolio
‡ Because portfolio M lies at the point of
tangency, it has the highest portfolio
possibility line
‡ verybody will want to invest in Portfolio
M and borrow or lend to be somewhere on
the CML
‡ Therefore this portfolio must include ALL
RISKY ASS TS
 The Market Portfolio
Because the market is in equilibrium, all
assets are included in this portfolio in
proportion to their market value
 The Market Portfolio
Because it contains all risky assets, it is a
completely diversified portfolio, which
means that all the unique risk of individual
assets (unsystematic risk) is diversified
away
 Systematic Risk
‡ Only systematic risk remains in the market
portfolio
‡ Systematic risk is the variability in all risky
assets caused by macroeconomic variables
‡ Systematic risk can be measured by the
standard deviation of returns of the market
portfolio and can change over time
 Mow to Measure Diversification
‡ All portfolios on the CML are perfectly
positively correlated with each other and
with the completely diversified market
Portfolio M
‡ A completely diversified portfolio would
have a correlation with the market portfolio
of +1.00
 Diversification and the
limination of Unsystematic Risk
‡ The purpose of diversification is to reduce the
standard deviation of the total portfolio
‡ This assumes that imperfect correlations exist among
securities
‡ As you add securities, you expect the average
covariance for the portfolio to decline
‡ Mow many securities must you add to obtain a
completely diversified portfolio? (At least 30 stocks
for a borrowing investor and 40 for a lending investor)
 Diversification and the
limination of Unsystematic Risk
Observe what happens as you increase the
sample size of the portfolio by adding
securities that have some positive
correlation
 Õumber of Stocks in a Portfolio and the
Standard Deviation of Portfolio Return
i .
    
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2 %


 

Ô 
 i .
  
 ,  1   
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i %

0%
 i  1  
The CML and the Separation Theorem
‡ The CML leads all investors to invest in the M
portfolio
‡ Individual investors should differ in position
on the CML depending on risk preferences
‡ Mow an investor gets to a point on the CML is
based on financing decisions
‡ Risk averse investors will lend part of the
portfolio at the risk-free rate and invest the
remainder in the market portfolio
The CML and the Separation Theorem
Investors preferring more risk might borrow
funds at the RFR and invest everything in
the market portfolio
The CML and the Separation Theorem
The decision to borrow or lend to obtain a
point on the CML is a separate decision
based on risk preferences (financing
decision)
 A Risk Measure for the CML
‡ Covariance with the M portfolio is the
systematic risk of an asset
‡ The Markowitz portfolio model considers
the average covariance with all other assets
in the portfolio
‡ The only relevant portfolio is the M
portfolio
A Risk Measure for the CML
Together, this means the only important
consideration is the asset¶s covariance with
the market portfolio
 A Risk Measure for the CML
Because all individual risky assets are part of the M portfolio, an
asset¶s rate of return in relation to the return for the M
portfolio may be described using the following linear model:
R it
a i b i R Mi |
 3
      &#  
   %  

  #     
,     ,#    &#  
|   %  %
Úariance of Returns for a Risky Asset
Úar R it
Úar a i iR i |

Úar a i Úar i R i Úar |

Úar i R i Úar |
Note t at Úar i R i is ariance re ate
to arket return or syste atic risk
Úar | is t e resi ua return not re ate to
t e arket ortfo io or unsyste at ic risk
The Capital Asset Pricing Model:
xpected Return and Risk
‡ CAPM indicates what should be the
expected or required rates of return on risky
assets
‡ This helps to value an asset by providing an
appropriate discount rate to use in dividend
valuation models
‡ You can compare an estimated rate of return
to the required rate of return implied by
CAPM - over under valued ?
The Security Market Line (SML)
‡ The relevant risk measure for an individual
risky asset is its covariance with the market
portfolio (Covi,m)
‡ This is shown as the risk measure
‡ The return for the market portfolio should
be consistent with its own risk, which is the
covariance of the market with itself - or its
variance:  „
 *
+4
Graph of Security Market Line
(SML)
( i )
i,5



„ o i
The Security Market Line (SML)
The equation for the risk-return line is
M -
( i) ( o iM)
M
o iM
( M- )
M
o
    

iM  O Ô u
M

E(R i )
RFR O Ô (R M - RFR)

 *
+6
Graph of SML with
Õormalized Systematic Risk
Ri
i,5

0 &

 


´
´ eta o im  M
 Determining the xpected
Rate of Return for a Risky Asset
(R i )
RFR O Ô (R M - RFR)
‡ The expected rate of return of a risk asset is
determined by the RFR plus a risk premium
for the individual asset
‡ The risk premium is determined by the
systematic risk of the asset (beta) and the
prevailing market risk premium (RM-RFR)
 Determining the xpected
Rate of Return for a Risky Asset
i
  
Assume: RFR = 6% (0.06)
A 0. 0 RM = 12% (0.12)
B 1.00
Implied market risk premium = 6% (0.06)
C 1.1
D 1. 0
0. 0
(R i )
RFR O Ô (R M RFR)

(RA) = 0.06 + 0.70 (0.12-0.06) = 0.102 = 10.2%

(RB) = 0.06 + 1.00 (0.12-0.06) = 0.120 = 12.0%

(RC) = 0.06 + 1.15 (0.12-0.06) = 0.129 = 12.9%

(RD) = 0.06 + 1.40 (0.12-0.06) = 0.144 = 14.4%

(R
) = 0.06 + -0.30 (0.12-0.06) = 0.042 = 4.2%
 Determining the
xpected
Rate of Return for a Risky Asset
‡ In equilibrium, all assets and all portfolios of assets
should plot on the SML
‡ Any security with an estimated return that plots
above the SML is underpriced
‡ Any security with an estimated return that plots
below the SML is overpriced
‡ A superior investor must derive value estimates for
assets that are consistently superior to the consensus
market evaluation to earn better risk-adjusted rates
of return than the average investor
 Identifying Undervalued and
Overvalued Assets
‡ Compare the required rate of return to the
expected rate of return for a specific risky
asset using the SML over a specific
investment horizon to determine if it is an
appropriate investment
‡ Independent estimates of return for the
securities provide price and dividend
outlooks
 Price, Dividend, and
Rate of Return
stimates
*
+7

  
   
     
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Comparison of Required Rate of Return
to
stimated Rate of Return
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 Plot of
stimated Returns

R i on SML Graph *
+8
(( Rm 
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 Calculating Systematic Risk:
The Characteristic Line
The systematic risk input of an individual asset is derived
from a regression model, referred to as the asset¶s
characteristic line with the model portfolio:
R i,t i â i R ,t â|
 3
          &#  
,         %  #   , &


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Scatter Plot of Rates of Return
Ô    *
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,
The Impact of the Time Interval
‡ Õumber of observations and time interval used in
regression vary
‡ Úalue Line Investment Services (ÚL) uses weekly
rates of return over five years
‡ Merrill Lynch, Pierce, Fenner & Smith (ML) uses
monthly return over five years
‡ There is no ³correct´ interval for analysis
‡ Weak relationship between ÚL & ML betas due to
difference in intervals used
‡ The return time interval makes a difference, and
its impact increases as the firm¶s size declines
 Relaxing the Assumptions
‡ Differential Borrowing and Lending Rates
± Meterogeneous
xpectations and Planning
Periods
‡ Zero Beta Model
± does not require a risk-free asset
‡ Transaction Costs
± with transactions costs, the SML will be a band
of securities, rather than a straight line
 Relaxing the Assumptions
‡ Meterogeneous
xpectations and Planning
Periods
± will have an impact on the CML and SML
‡ Taxes
± could cause major differences in the CML and
SML among investors

mpirical Tests of the CAPM
‡ Stability of Beta
± betas for individual stocks are not stable, but
portfolio betas are reasonably stable. Further,
the larger the portfolio of stocks and longer
the period, the more stable the beta of the
portfolio
‡ Comparability of Published
stimates of
Beta
± differences exist. Mence, consider the return
interval used and the firm¶s relative size
Relationship Between Systematic
Risk and Return
‡
ffect of Skewness on Relationship
± investors prefer stocks with high positive
skewness that provide an opportunity for very
large returns
‡
ffect of Size, P
, and Leverage
± size, and P
have an inverse impact on returns
after considering the CAPM. Financial
Leverage also helps explain cross-section of
returns
Relationship Between Systematic
Risk and Return
‡
ffect of Book-to-Market Úalue
± Fama and French questioned the relationship
between returns and beta in their seminal 1992
study. They found the BÚ
MÚ ratio to be a key
determinant of returns
‡ Summary of CAPM Risk-Return
mpirical
Results
± the relationship between beta and rates of return
is a moot point
 The Market Portfolio: Theory
versus Practice
‡ There is a controversy over the market portfolio.
Mence, proxies are used
‡ There is no unanimity about which proxy to use
‡ An incorrect market proxy will affect both the beta
risk measures and the position and slope of the
SML that is used to evaluate portfolio
performance