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CHAPTER 9

CHAPTER 9. The Capital Asset Pricing Model. 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

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CHAPTER 9

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  1. CHAPTER 9 The Capital Asset Pricing Model

  2. 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 Capital Asset Pricing Model (CAPM)

  3. 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: myopic-short-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) Assumptions

  4. 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 Assumptions Continued

  5. 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 Resulting Equilibrium Conditions

  6. Figure 9.1 The Efficient Frontier and the Capital Market Line

  7. 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 Resulting Equilibrium Conditions Continued

  8. 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. 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 Return and Risk For Individual Securities

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

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

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

  13. Figure 9.2 The Security Market Line

  14. Figure 9.3 The SML and a Positive-Alpha Stock Alpha: the difference between the fair and the actual expected rates of return

  15. 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

  16. 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 non-traded assets Merton’s Multiperiod Model and hedge portfolios Incorporation of the effects of changes in the real rate of interest and inflation

  17. 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

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

  19. Figure 9.5 The Relationship Between Illiquidity and Average Returns

  20. 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:

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