INVESTMENTS | BODIE, KANE, MARCUSCopyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/IrwinCHAPTER 9The Capital Asset Pricing ModelINVESTMENTS | BODIE, KANE, MARCUS It is the equilibrium model that underlies all modern financial theory Derived using principles of diversification with simplified assumptions Markowitz, Sharpe, Lintner and Mossin are researchers credited with its developmentCapital Asset Pricing Model (CAPM)2INVESTMENTS | BODIE, KANE, MARCUSAssumptions Individual investors are price takers Single-period investment horizon Investments are limited to traded financial assets No taxes and transaction costs Information is costless and available to all investors Investors are rational mean-variance optimizers There are homogeneous expectations3INVESTMENTS | BODIE, KANE, MARCUS All investors will hold the same portfolio for risky assets market portfolio Market portfolio contains all securities and the proportion of each security is its market value as a percentage of total market valueResulting Equilibrium Conditions4INVESTMENTS | BODIE, KANE, MARCUS 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 marketResulting Equilibrium Conditions5INVESTMENTS | BODIE, KANE, MARCUSFigure 9.1 The Efficient Frontier and the Capital Market Line6INVESTMENTS | BODIE, KANE, MARCUSMarket Risk PremiumThe risk premium on the market portfolio will be proportional to its risk and the degree of risk aversion of the investor:7INVESTMENTS | BODIE, KANE, MARCUS The risk premium on individual securities is a function of the individual securitys contribution to the risk of the market portfolio. An individual securitys risk premium is a function of the covariance of returns with the assets that make up the market portfolio.Return and Risk For Individual Securities8INVESTMENTS | BODIE, KANE, MARCUSGE Example Covariance of GE return with the market portfolio: Therefore, the reward-to-risk ratio for investments in GE would be:9INVESTMENTS | BODIE, KANE, MARCUSGE Example Reward-to-risk ratio for investment in market portfolio: Reward-to-risk ratios of GE and the market portfolio should be equal:10INVESTMENTS | BODIE, KANE, MARCUSGE Example The risk premium for GE: Restating, we obtain:11INVESTMENTS | BODIE, KANE, MARCUSExpected Return-Beta Relationship CAPM holds for the overall portfolio because: This also holds for the market portfolio:12INVESTMENTS | BODIE, KANE, MARCUSFigure 9.2 The Security Market Line13INVESTMENTS | BODIE, KANE, MARCUSFigure 9.3 The SML and a Positive-Alpha Stock14INVESTMENTS | BODIE, KANE, MARCUSThe Index Model and Realized Returns To move from expected to realized returns, use the index model in excess return form: The index model beta coefficient is the same as the beta of the CAPM expected return-beta relationship.15INVESTMENTS | BODIE, KANE, MARCUSFigure 9.4 Estimates of Individual Mutual Fund Alphas, 1972-199116INVESTMENTS | BODIE, KANE, MARCUSIs the CAPM Practical? CAPM is the best model to explain returns on risky assets. This means:Without security analysis, is assumed to be zero. Positive and negative alphas are revealed only by superior security analysis.17INVESTMENTS | BODIE, KANE, MARCUSIs the CAPM Practical? We must use a proxy for the market portfolio. CAPM is still considered the best available description of security pricing and is widely accepted.18INVESTMENTS | BODIE, KANE, MARCUSEconometrics and the Expected Return- Beta Relationship Statistical bias is easily introduced. Miller and Scholes paper demonstrated how econometric problems could lead one to reject the CAPM even if it were perfectly valid.19INVESTMENTS | BODIE, KANE, MARCUSExtensions 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 assets20INVESTMENTS | BODIE, KANE, MARCUSExtensions of the CAPM Mertons Multiperiod Model and hedge portfolios Incorporation of the effects of changes in the real rate of interest and inflation Consumption-based CAPM Rubinstein, Lucas, and Breeden Investors allocate wealth between consumption today and investment for the future21INVESTMENTS | BODIE, KANE, MARCUSLiquidity and the CAPM Liquidity: The ease and speed with which an asset can be sold at fair market value Illiquidity Premium: Discount from fair market value the seller must accept to obtain a quick sale. Measured partly by bid-asked spread As trading costs are higher, the illiquidity discount will be greater.22INVESTMENTS | BODIE, KANE, MARCUSFigure 9.5 The Relationship Between Illiquidity and Average Returns23INVESTMENTS | BODIE, KANE, MARCUSLiquidity Risk In a financial crisis, liquidity can unexpectedly dry up. When liquidity in one sto