7-1 McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. CHAPTER 7 Capital Asset Pricing Model

7-2 Capital Asset Pricing Model (CAPM) CAPM is a theory of the relationship between risk and return CAPM underlies all modern finance

7-3 CAPM Assumptions Information is costless and available to all investors Investors are risk averse Investors make optimal investment decisions Homogeneous expectations

7-4 CAPM Resulting Equilibrium Conditions Investors will diversify All investors hold the same portfolio of risky assets – the market portfolio Market portfolio contains all available in the market

7-5 Total Risk & Systematic Risk Total Risk = Systematic + Firm-specific Risk Risk Because firm-specific risk can be eliminated by diversifying, the only risk that is relevant to diversified investors is systematic risk (measured by beta)

7-6 Security Market Line According to CAPM, the required return on a security (or portfolio) is shown by the Security Market Line (SML). The SML relationship can be shown algebraically or graphically. r X = r f +  X (ER M – r f ) Where r X = required return on X ER M – r f = Market risk premium

7-7 r E(r M ) rfrfrfrf SML M ß ß = 1.0 Security Market Line

7-8 Sample Calculations for SML ER m = 14% r f = 6%  x = 1.20 r x = (8) = 15.6%

7-9 Market Equilibrium The expected (or predicted) return for a security equals its required return only if the security is fairly priced; in other words, if a market equilibrium exists.

7-10 Disequilibrium Example Suppose Security X with a  of 1.2 has a predicted return of 17% According to SML, its required return is 15.6% X is underpriced in the market: it offers too high of a rate of return for its level of risk

7-11 Figure 7.2 The Security Market Line and Positive Alpha Stock

7-12 Disequilibrium Example For Stock X, with a predicted return of 17% and a required return of 15.6%:  X = predicted return – required return = 17% % =1.4% Stocks with positive alphas are undervalued. Their predicted returns plot above the SML.

7-13 Estimating Betas Stock betas are estimated using historical data on a stock index and individual securities Returns for individual stocks are regressed against the returns for the stock index Slope is the beta for the individual stock

7-14 Figure 7.4 Characteristic Line for GM

7-15 Predicting Betas The beta from the regression equation is an estimate based on past history Betas exhibit a statistical property: – Regression toward the mean

7-16 CAPM Limitations of CAPM: – Market Portfolio is not directly observable (Roll’s critique) – Research shows that other factors affect returns

7-17 Fama French Three-Factor Model Returns are related to three factors: – Size – Book value relative to market value – Beta Three factor model describes returns better than beta alone