CHAPTER NINE

1
CHAPTER NINE

• THE CAPITAL ASSET PRICING MODEL

2
THE CAPM ASSUMPTIONS

• NORMATIVE ASSUMPTIONS
• expected returns and standard deviation cover a
  one-period investor horizon
• nonsatiation
• risk averse investors
• assets are infinitely divisible
• risk free asset exists
• no taxes nor transaction costs

3
THE CAPM ASSUMPTIONS

• ADDITIONAL ASSUMPTIONS
• one period investor horizon for all
• risk free rate is the same for all
• information is free and instantaneously available
• homogeneous expectations

4
THE CAPITAL MARKET LINE

• THE CAPITAL MARKET LINE (CML)
• the new efficient frontier that results from risk
  free lending and borrowing
• both risk and return increase in a linear fashion
  along the CML

5
THE CAPITAL MARKET LINE
CML

• THE CAPITAL MARKET LINE

rP
M
rfr
sP
6
THE CAPITAL MARKET LINE

• THE SEPARATION THEOREM
• James Tobin identifies
• the division between the investment decision and
  the financing decision

7
THE CAPITAL MARKET LINE

• THE SEPARATION THEOREM
• to be somewhere on the CML, the investor
  initially
• decides to invest and
• based on risk preferences makes a separate
  financing decision either
• to borrow or
• to lend

8
THE MARKET PORTFOLIO

• DEFINITION the portfolio of all risky assets
  which contains
• complete diversification
• a central role in the CAPM theory which is the
  tangency portfolio (M) with the CML

9
THE SECURITY MARKET LINE (SML)

• FOR AN INDIVIDUAL RISKY ASSET
• the relevant risk measure is its covariance with
  the market portfolio (si, M)
• DEFINITION the security market line expresses
  the linear relationship between
• the expected returns on a risky asset and
• its covariance with the market returns

10
THE SECURITY MARKET LINE (SML)

• THE SECURITY MARKET LINE
• or
• where

11
THE SECURITY MARKET LINE (SML)

• THE SECURITY MARKET LINE
• THE BETA COEFFICIENT
• an alternative way to represent the covariance of
  a security

12
THE SECURITY MARKET LINE (SML)

• THE SECURITY MARKET LINE
• THE BETA COEFFICIENT
• of a portfolio
• is the weighted average of the betas of its
  component securities

13
THE SECURITY MARKET LINE (SML)

• THE SECURITY MARKET LINE

SML
E(r)
rM
rrf
b
b 1.0
14
THE MARKET MODEL

• FROM CHAPTER 7
• assumed return on a risky asset was related to
  the return on a market index

15
THE MARKET MODEL

• DIFFERENCES WITH THE CAPM
• the market model is a single-factor model
• the market model is not an equilibrium model like
  the CAPM
• the market model uses a market index,
• the CAPM uses the market portfolio

16
THE MARKET MODEL

• MARKET INDICES
• the most widely used and known are
• SP 500
• NYSE COMPOSITE
• AMEX COMPOSITE
• RUSSELL 3000
• WILSHIRE 5000
• DJIA

17
THE MARKET MODEL

• MARKET AND NON-MARKET RISK
• Recall that a securitys total risk may be
  expressed as

18
THE MARKET MODEL

• MARKET AND NON-MARKET RISK
• according to the CAPM
• the relationship is identical except the market
  portfolio is involved instead of the market index

19
THE MARKET MODEL

• MARKET AND NON-MARKET RISK
• Why partition risk?
• market risk
• related to the risk of the market portfolio and
  to the beta of the risky asset
• risky assets with large betas require larger
  amounts of market risk
• larger betas mean larger returns

20
THE MARKET MODEL

• MARKET AND NON-MARKET RISK
• Why partition risk?
• non-market risk
• not related to beta
• risky assets with larger amounts of seI will not
  have larger E(r)
• According to CAPM
• investors are rewarded for bearing market risk
  not non-market risk

21

• END OF CHAPTER 9