Chapter 11:

The CAPM
Corporate Finance
Outline
 Portfolio theory
 The CAPM (Capital Asset Pricing Model)
Expected return with ex ante
probabilities
 Investing usually needs to deal with uncertain
outcomes.
 That is, the unrealized return can take on any
one of a finite number of specific values, say r1,
r2, …, rS.
 This randomness can be described in
probabilistic terms. That is, for each of these
possible outcomes, they are associated with a
probability, say p1, p2, …, pS.
 For asset i, its expected return is: E(r ) = p * r +
i 1 1
p2* r2 + … + pS * rS.
An example, I
GE ATT K
State Prob. r
s=1: cold 0.25 -0.1 -0.3 0
s=2: normal 0.5 0.1 0.2 0.08
s=3: hot 0.25 0.2 0.4 0.16
1
E(r_i) 0.075 0.125 0.08
Portfolio variability measures
with ex ante probabilities
 The usual variability measure for a portfolio is variance
(and standard deviation); holding other factors constant,
the lower the variance (and std.), the better.
 Variance (and std.) measures the degree of possible
deviations from the expected return.
Formulas
 Var(r) = p * (E(r) – r )2 + p * (E(r) – r )2 + … + p
1 1 2 2 S
* (E(r) – rS)2.
 Std(r) = Var(r)1/2.
 Variance and standard deviation are non-
negative.
 Standard deviation has the unit as the original
data, whereas variance is just a number (has no
unit). For this reason, practitioners prefer using
standard deviation.
An example, II
GE ATT K
State Prob. r
s=1: cold 0.25 -0.1 -0.3 0
s=2: normal 0.5 0.1 0.2 0.08
s=3: hot 0.25 0.2 0.4 0.16
E(r) 0.075 0.125 0.08
Var(r) 0.01188 0.06688 0.0032
Std(r) 0.10897 0.2586 0.05657
2-asset diversification, I
 Suppose that you own $100 worth of IBM shares. You
remember someone told you that diversification is
beneficial. You are thinking about selling 50% of your
IBM shares and diversifying into one of the following two
stocks: H1 or H2.
 H1 and H2 have the same expected rate of return and
variance (std.).
Portfolio return
 Portfolio weight for asset i, w , is the ratio of market value
i
of i to the market value of the portfolio.
 The return of a portfolio is the weighted (by portfolio
weights) average of returns of individual assets.
 The expected return of a portfolio is the weighted (by
portfolio weights) average of expected returns of
individual assets.
2-asset diversification, II
IBM H1 H2 IBM and H1 IBM and H2
State Prob. r 50%/50% 50%/50%
S1: cold 0.25 -0.1 0 0.1 -0.05 0
S2: normal 0.5 0.1 0.05 0.05 0.075 0.075
S3: hot 0.25 0.3 0.1 0 0.2 0.15
E(r) 0.1 0.05 0.05 0.075 0.075
Var(r) 0.02 0.0013 0.0013 0.0078125 0.0028125
Std(r) 0.1414 0.0354 0.0354 0.08838835 0.053033

Which portfolio is better?

2-asset diversification,
III
 H1 and H2 have the same expected return and
variance (std.).
 Why adding H2 is better than adding H1?
 The answer is: correlation coefficient.
 The correlation coefficient between IBM and
and H2 is lower than that between IBM and H1.
 That is, with respect to IBM’s return behavior,
the return behavior of H2 is more unique than
that of H1.
 Return uniqueness is good!
Correlation coefficient
 Correlation coefficient measures the mutual
dependence of two random returns.
 Correlation coefficient ranges from +1
(perfectly positively correlated) to -1 (perfectly
negatively correlated).
 Cov(IBM,H1) = p * (E(r ) – r
1 IBM IBM, 1) * (E(rH1) – rH1, 1)
+ p2* (E(rIBM) – rIBM, 2) * (E(rH1) – rH1, 2) + … + pS *
(E(rIBM) – rIBM, S) * (E(rH1) – rH1, S).
 = Cov(IBM,H1) / (Std(IBM) * Std(H1) ).
IBM, H1

 : correlation coefficient.
2-asset diversification,
IV
IBM H1 H2
State Prob. r
S1: cold 0.25 -0.1 0 0.1
S2: normal 0.5 0.1 0.05 0.05
S3: hot 0.25 0.3 0.1 0
E(r) 0.1 0.05 0.05
Var(r) 0.02 0.0013 0.0013
Std(r) 0.1414 0.0354 0.0354
Cov with IBM 0.005 -0.005
r with IBM 1 -1
The opportunity set:  =
1
IBM H1
State Prob. r
S1: cold 0.25 -0.1 0
S2: normal 0.5 0.1 0.05
S3: hot 0.25 0.3 0.1

w_IBM 1 0.75 0.5 0.25 0

w_H1 0 0.25 0.5 0.75 1
S1: cold 0.25 -0.1 -0.075 -0.05 -0.025 0
S2: normal 0.5 0.1 0.0875 0.075 0.0625 0.05
S3: hot 0.25 0.3 0.25 0.2 0.15 0.1
E(r) 0.1 0.0875 0.075 0.0625 0.05
Std(r) 0.1414 0.1149 0.0884 0.0619 0.0354
0.1 0.0875 0.075 0.0625 0.05
0.12
0.1
0.08
E(r)

0.06
0.04
0.02
0
0 0.05 0.1 0.15
The opportunity set:  =
-1
IBM H2
State Prob. r
S1: cold 0.25 -0.1 0.1
S2: normal 0.5 0.1 0.05
S3: hot 0.25 0.3 0

w_IBM 1 0.75 0.5 0.25 0.2 0.15 0

w_H2 0 0.25 0.5 0.75 0.8 0.85 1
S1: cold 0.25 -0.1 -0.05 0 0.05 0.06 0.07 0.1
S2: normal 0.5 0.1 0.0875 0.075 0.0625 0.06 0.0575 0.05
S3: hot 0.25 0.3 0.225 0.15 0.075 0.06 0.045 0
E(r) 0.1 0.0875 0.075 0.0625 0.06 0.0575 0.05
Std(r) 0.1414 0.0972 0.053 0.0088 7E-18 0.0088 0.0354
0.10.120.0875 0.075 0.0625 0.06 0.0575 0.05
0.1
0.08
E(r)

0.06
0.04
0.02
0
0 0.05 0.1 0.15
2-asset diversification
So, these are what we
have so far:
 The shape of the combinations of 2 assets is like a rubber
band.
 With a low correlation coefficient, you can pull the rubber
band further to the left, which is good.
 Holding other factors constant, the lower the correlation
coefficient, the better.
 Again, return uniqueness is healthy!
2-asset formulas
 It turns out that there are nice formulas for calculating
the expected return and standard deviation of a 2-asset
portfolio. Let the portfolio weight of asset 1 be w. The
portfolio weight of asset 2 is thus (1 – w).
 E(r) = w * E(r ) + (1 – w) * E(r ).
1 2

 Std(r) = (w2 * Var(r ) + 2* w * (1 – w) * cov(1,2) + (1 – w)2

1
* Var(r2))1/2.
Now, let us work on  = 0, i.e.,
Cov=0

E(r ) Var(r ) Cov ()

IBM 0.1 0.02
H3 0.05 0.0013 0

IBM 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2

H3 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8
E(r) 0.1 0.095 0.09 0.085 0.08 0.075 0.07 0.07 0.06
Std(r) 0.141 0.1273 0.113 0.1 0.086 0.073 0.06 0.05 0.04
0.1 0.095 0.09 0.085 0.08 0.075 0.07 0.065 0.06
0.12

0.1

0.08
E(r)

0.06

0.04

0.02

0
0 0.05 0.1 0.15
Std.
N risky assets

return nt ier
ent fro
c i
effi
minimum
variance
portfolio

Individual Assets

P
The section of the opportunity set above the minimum variance
portfolio is the efficient frontier.
N-asset + Rf
diversification
Selecting an optimal portfolio
from N>2 assets
 The upper part of the bullet-shape solid line is the efficient
frontier (EF): the set of portfolios that have the highest
expected return given a particular level of risk (std.).
 Given the EF, selecting an optimal portfolio for an investor
who are allowed to invest in a combination of N risky assets
is rather straightforward.
 One way is to ask the investor about the comfortable level of
standard deviation (risk tolerance), say 20%. Then,
corresponding to that level of std., we find the optimal
portfolio on the EF, say the portfolio E shown in the previous
figure.
 CAL (capital allocation line): the set of feasible expected
return and standard deviation pairs of all portfolios resulting
from combining the risk-free asset and a risky portfolio.
What if one can invest in the
risk-free asset?
 If we add the risk-free asset to N risky assets, we can
enhance the efficient frontier (EF) to the red line shown in
the previous figure, i.e., the straight line that passes
through the risk-free asset and the tangent point of the
efficient frontier (EF).
 Let us called this straight line “enhanced efficient
frontier” (EEF).
Enhanced efficient
frontier (EEF)
 With the risk-free asset, EEF will be of interest
to rational investors who do not like standard
deviation and like expected return.
 Why EEF pass through the tangent point? The
reason is that this line has the highest slope;
that is, given one unit of std. (variance), the
associated expected return is the highest.
 Why EEF is a straight line? This is because the
risk-free asset, by definition, has zero variance
(std.) and zero covariance with any risky asset.
Separation, I
 When the risk-free asset is available, any efficient
portfolio (any point on the EEF) can be expressed as a
combination of the tangent portfolio and the risk-free
asset.
 Implication: in terms of choosing risky investments, there
will be no need for anyone to purchase individual stocks
separately or to purchase other risky portfolios; the
tangent portfolio is enough.
Separation, II
 Once an investor makes the above “investment”
decision, i.e., finding the tangent portfolio, the remaining
task will be a “financing” decision. That is, including the
risk-free asset (either long or short) such that the
resulting efficient portfolio meets the investor’s risk
tolerance.
 The “financing” decision is independent (separation) of
the “investment” decision.
EEF vs. EF
 EEF is almost surely better off than EF, except for the
tangent portfolio.
 In other words, adding the risk-free asset (either a long or
short position) into a risky portfolio is almost surely
beneficial.
 Why? [hint: correlation coefficient].
When you hold a well-diversified
portfolio, I
When you hold a well-diversified
portfolio, II
 When one holds a well-diversified portfolio, the so called
diversifiable (unsystematic, or idiosyncratic) risk
disappears.
 Unsystematic risk: the type of risk that affects a limited
number of assets.
 Because unsystematic risk can be easily diversified away
by holding a large number of assets, rational investors
would not want unsystematic risk in their portfolios.
 Thus, this type of risk does not require risk premium.
 Risk premium: the difference between expected return
and the risk-free rate.
When you hold a well-diversified
portfolio, III
 Even when one holds a well-diversified
portfolio, the so called un-diversifiable ( or
systematic) risk will not be reduced.
 Systematic risk: the type of (market-wide) risk
that affects a large number of assets.
 Because systematic risk cannot be diversified
away, investors need to live with it (monkey on
the shoulder) when investing in risky securities.
 Thus, this type of risk does require risk
premium.
Beta as a measure of systematic
risk
 Systematic risk matters!
 We use the beta coefficient to measure systematic risk.
 Beta: a measure of the responsiveness of a security to
movements in the market. Betai = Cov (i, m) / Var (m).
More about beta
 What does beta tell us?
 A beta < 1 implies the asset has less systematic risk than the
overall market.
 A beta > 1 implies the asset has more systematic risk than
the overall market.
 The overall market has a beta of 1.
 The beta of the risk-free asset is 0. Why?
Total risk vs. systematic
risk
 Consider the following information:
Standard Deviation
Beta
 Security A 15% 1.50
 Security B 30% 0.50
 Which security has more total risk?
 Which security has more systematic risk?
 Which security should have a higher expected return?
Risk, again
 For a portfolio, we care about variance and
standard deviation.
 But this risk concept at portfolio level does not
automatically carry forward to individual
security level.
 For a security, we care about beta.
 The reason is that variances and standard
deviations do not add up. They may cancel one
another out.
Beta and risk premium
 So far, we know that beta is a measure of systematic risk,
and bearing systematic risk requires compensation in the
form of extra return (expected return).
 Thus, the higher the beta, the greater the risk premium.
 This relationship is depicted in the following figure.
Red line  priced correctly;
rf = 6%

underpricing

Overpricing
Reward-to-risk ratio
 The reward-to-risk ratio is the slope of the red
line illustrated in the previous figure: slope =
(E(ri) – rf) / (i – 0).
 The red line is called “security market line
(SML).”
 What if an asset, j, has a higher reward-to-risk
ratio than the red line?
 j is an bargain and the market is not in
equilibrium. Investors (and their demand) will
bid up j’s price, drive down its expected return,
and make its reward-to-risk ratio equal to that
of the red line.
Equilibrium argument
 The previous equilibrium argument ensures that
all assets and portfolios will have the same
reward-to-risk ratio and they all must equal the
reward-to-risk ratio of the overall market, i.e.,
the market portfolio.
 That is, (E(r ) – r ) / i = (E(rm) – rf) / m.
i f

 Recall that m = 1.
 Then, we have the CAPM: E(r ) = r + i × (E(rm)
i f
– rf).
 E(r ) is the expected return for asset i when the
i
CAPM holds; i.e., when the CAPM is correct.
The CAPM
 The CAPM says that in equilibrium, all securities and
portfolios should fall on the security market line, i.e., the
red line.
 That is, the higher the beta, the higher the expected
return.
 When one uses the CAPM, the required return
demanded by shareholders is the expected return under
the CAPM. For capital budgeting, the required return is
frequently called the cost of equity: i.e., the return
required by equity (stock market) investors.
 When a stock is expected to have a return that is
different from the expected return under the CAPM, we
have a mispricing situation.
A sample question
 Given the following information: The risk-free rate is 7%,
the beta of stock A is 1.2, the beta of stock B is 0.8, the
expected return on stock A is 13.5%, and the expected
return on stock B is 11.0%. Further, we know that stock
A is fairly priced and that the betas of stocks A and B are
correct. Which of the following regarding stock B must
be true?
 a. Stock B is also fairly priced.
 b. The expected return on stock B is too high.
 c. The price of stock B is too high.
 d. The price of stock A is too high.
 e. None of the above.
An example
 Suppose that the beta estimate for MMM is 1.5
(finance.yahoo.com). The current T-bill rate is 5%. We
know that historical risk premium for S&P 500 Index is
about 8.5%. What is the cost of equity for MMM?
 E(r ) = r + i × (E(rm) – rf) = 5% + 1.5 × 8.5% = 17.75%.
i f
Portfolio beta
 The beta of a portfolio is the weighted average (weighted
by portfolio weights) of the betas of underlying
assets/securities.
 Example: 40% of capital is invested in stock A that has a
beta of 2. The remaining 60% of capital is invested in
stock B that has a beta of 1. The beta for the portfolio is
thus 1.4 = 0.4 × 2 + 0.6 × 1.
 Betas do add up; they cannot cancel one another out.
All-equity firms
 One uses the cost of equity as the discount rate if (1) the
firm uses no debt, or (2) the cash flows being discounted
are the kind of cash flows available to equityholders; e.g.,
cash dividends.
 If the previous firm (i.e., MMM) uses no debt, the required
return (the discount rate) for evaluating a new project (in
terms of computing the NPV) is the cost of equity,
17.75%.
A sample question
 Assuming the CAPM holds, what is the cost of equity for a
firm if the firm's equity has a beta of 1.2, the risk-free
rate of return is 2%, the expected return on the market is
9%, and the return to the company's debt is 7%?
a. 10.4%
b. 10.8%
c. 12.8%
d. 14.4%
e. None of the above.
This is the way practitioners
estimate 
Characteristic line
 The previous regression line is called the characteristic
line.
 The slope of the characteristic line is an estimate of .
 The intercept term estimate is called “alpha.”
Is the CAPM a good
model?
 It is a beautiful model.
 It does not have desirable empirical properties.
 In recent years, more and more people would like to see
a better way of estimating the cost of equity.
 Possible directions: multi-factor models? real-option-
based models?
A sample question
 The risk premium is the difference between the expected
return on a risky asset and the return on:
 a. Another risky asset.
 b. The risk-free asset.
 c. The market portfolio.
 d. A market index.
 e. A bank account.
A sample question
 A stock yielded the following historical returns:
10%, -2%, 3%, -1%, and 15%. What is the
covariance between the stock and the risk-free
asset?
 a. Not enough information for solving this
problem.
 b. 7.31%.
 c. 5%.
 d. 0.0053.
 e. 0.
Assignment?
 Suppose that mutual fund A has an expected return of
9% and a standard deviation of 20%. Mutual fund B has
an expected return of 14% and a standard deviation of
30%. The correlation coefficient between A and B is -0.1.
(1) Please plot the feasible set or the opportunity set,
i.e., attainable portfolios, by alternating the mix between
the two funds. (2) What are the expected return and
standard deviation for a portfolio comprised of 60% fund
A and 40% fund B? (3) Suppose that the risk-free asset
has an expected return of 4%. Using only fund B and the
risk-free asset, plot the feasible set.
 Due in a week.
End-of-chapter
 Concept questions: 1-10.
 Questions and problems: 1-32.