Asset Pricing Model

Topics Covered
• Understand the Capital Asset Pricing Model
(CAPM) and its uses.
• Explain why diversification is beneficial.
• Role and Validity of CAPM
• Arbitrage Pricing Theory
• Multifactor Models
 Market Price of Risk

The gradient of the CML is given by:

[E(rM) -rF] /M
E(rM) and are the expected return of the market portfolio
rF is the risk-free return

This indicates the reward that investors will

achieve (in terms of an expected return in excess
of the risk-free return) for bearing risk - it is
referred to as the market price of risk.
 Market Price of Risk
Suppose: E(rM) = 16%, M = 3%, rF = 10%, then the market price of
risk would equal

[E(rM) -rF] / = (16% - 10%) / 3% = 2

This indicates that for every 1% of risk, the investor can expect to
receive a return of 2% above the risk-free return.
So an investor willing to take a 4% risk in her portfolio, could expect
to receive a return of:

10% + (2 x 4%) = 18%

That is, an investor who is willing to bear risk at 4% would expect a

return of 18%.
 Asset Pricing Models
• These models provide a relationship between
an asset’s required rate of return and its risk.
• The required return can be used for:
– computing the NPV of an asset.
– valuing an asset.
 The Capital Asset Pricing Model (CAPM)
• Asset pricing models provide a relationship between an
asset’s required rate of return and its risk.
• The CAPM can be developed from the Capital Market Line
(CML).
– CML represents the collection of the best portfolio ( highest possible
expected return for any level of volatility).
– Individual securities might not lie on the CML. CAPM allows
us to determine the required rate of return for an individual security.
• When applied to financial securities, the relationship in the
CAPM between risk and return for an individual asset is
referred to as the Security Market Line (SML).
 Assumptions of the CAPM
• Investors can borrow and lend at the risk-
free rate
• Investors hold only efficient portfolios
• Investors have homogeneous expectations
• Individual investors are price takers
• Single-period investment horizon
• Investments are limited to traded financial
assets
 Assumptions of the CAPM
• No taxes and transaction costs
• Information is costless and available to all
investors
• Investors are rational mean-variance
optimizers
 Capital Market line
Equation of CML is:
E(RM ) - Rf
E(Ri) = Rf + σi
σM

E(Ri) is return on portfolio I

Rf risk free return
σi standard deviation of portfolio i
 Security Market Line
• CML exhibits the linear relationship between expected return
and standard deviation of efficient portfolios
• SML exhibits the relationship between expected return and
risk of individual securities and efficient portfolios
• Given that the only relevant risk for an individual asset i is the
covariance between the asset’s return and the return on
market, Cov (i,M) then the expected return of the security is

E(RM ) - Rf
E(Ri) = Rf + , Cov (i,M)
σ2M
 The CAPM

• The Capital Asset Pricing Model (CAPM) is

R i  RF  β i  ( R M  RF )
Expected
Risk- Beta of the Market risk
return on = + ×
free rate security premium
a security
 When ß i = 0, then the expected return is RF.
 When ß i = 1, then Ri  R M
 What does the SML tell us?
• SML provides a benchmark rate of return for
evaluation of investment performance
• The required rate of return on a security depends on:
– the risk free rate
– the “beta” of the security, and
– the market price of risk.
• The required return is a linear function of the beta
coefficient.
– All else being the same, the higher the beta
coefficient, the higher is the required return on
the security.
 Inputs of CAPM
Risk Free Rate
• Free from default risk
• Return uncorrelated to any economic development
• Theoretically a zero beta portfolio
• Practically, T bills or money market MF schemes
Risk Premium
• based on historic data
• Difference between average return on stocks and average risk
free rate
• Arithmetic or Geometric mean can be used to determine
average returns
• What Drives Market Risk Premium?
 Non diversifiable Risk- Beta

• Beta measures the risk that an individual asset adds

to the market portfolio.
• Since the market portfolio is “fully” diversified, beta
measures the risk that cannot be diversified away.
• Thus, beta is a measure of the asset’s non
diversifiable risk.
• Total Risk = Diversifiable risk + Non diversifiable risk.
Single Index Model
 Systematic Risk -Beta (ß)

• Beta is a standardised measure of systematic risk

• Beta is the contribution of a security to the risk of
the market portfolio.
• Beta measures responsiveness of a security to
changes in market return.
• “average” beta = 1
N

w
i 1
i i  1.

weights of market portfolio

 Interpreting the Beta Coefficient
• Beta also indicates how sensitive a security’s returns
are to changes in the market portfolio’s return.
– It is a measure of the asset’s risk.
• Suppose the market portfolio’s return is +10% above
the riskless return during a given period.
– if  = 1.50, the security’s return will be +15% above.
– if  = 1.00, the security’s return will be +10% above.
– if  = 0.50, the security’s return will be +5% above.
– if  = – 0.50, the security’s return will be – 5% above.
 Computing Required Rates of
Return
Common shares of Reliance Industries Ltd. (RIL)
have a correlation coefficient of 0.80 with the
market portfolio, and a standard deviation of
28%.
The expected return on the market portfolio is
14%, and its standard deviation is 20%. The risk
free rate is 5%.
What is the required rate of return on RIL?
 Required Return on RIL
First compute the beta of RIL:
 Ril, M  Ril
 RIL 
M
0.80  28
 RIL   1.12
20

Next, apply the CAPM:

rRIL  r f   RIL ( rM  r f )
r  5%  1.12  (14%  5%)  15.08%
 Required Rate of Return on RIL
• What would be the required rate of return
on RIL if it had a correlation of 0.50 with
the market, and a standard deviation of
28%. The expected return on the market
portfolio is 14%, and its standard deviation
is 20%. The risk free rate is 5%?
– Beta = 0.70 and rril = 11.30%
 Required Rate of Return on RIL
• What would be the required rate of return
on RIL if it had a standard deviation of 36%,
and a correlation of 0.80? (All else is the
same.)
– Beta = 1.44 and rRIL = 17.96%
 Estimating the Beta Coefficient
If we know the security’s covariance with the
market and the variance of the market, we can
use the definition of beta:

Cov( j , M )
j 
 2M

• Generally, these quantities are not known.

• We usually rely on their historical values to
provide us with an estimate of beta.
 Estimating the Beta Coefficient

Using historical values of rj, rf, and rM, we can run the
following linear regression to estimate the :

~
rj  rf   j (rM  rf )

This equation is called the Characteristic Line of

security j
 The Characteristic Line of Stock
• To run the regression, monthly observations from January
2017 to December 2018 were obtained for the following:
– Return on stock.
– Return on 90-day Treasury Bills.
– Return on Nifty
• The regression was carried out using these 24 observations.
• The slope of the regression line was 1.40, which is the beta
coefficient of stock.
The Characteristic Line of BEML
12%

rBEML - rf
8%

4%
 = 1.40

0%
-6% -4% -2% 0% 2% 4% 6%
rM - r f
-4%

-8%
Excel
 Interpreting the Beta Coefficient

The beta of the market portfolio is always equal to 1.0:

Because CovM , M  1 COVM , M

M  1
 2M

The beta of the risk-free asset is always equal to 0:

Because  r f  0 r ,M r
r  f f
0
f
M
 Estimation Issues
• Estimation Period

• Return Interval

• Use of Market Index

Estimating Levered Beta Using the “Bottoms-
Up” Approach

Brocade’s beta estimated using historical data is .88 and its current debt-to-
equity ratio is .256.
What is the firm’s estimated levered beta using the “bottoms-up” methodology?
If the firms in the same industry have following levered beta and debt to equity
ratio

Firm Levered Debt / Equity

Beta
EMC 1.62 .301
Sandisk 1.44 .285
Western Digital 1.51 .273
NetApp Inc. 1.83 .254
Terredata 1.12 .149
Estimating Levered Beta Using the “Bottoms-
Up” Approach
Brocade’s beta estimated using historical data is .88 and its current debt-to-equity ratio is .256.
What is the firm’s estimated levered beta using the “bottoms-up” methodology?
Step 1: Select sample of firms having similar Step 2: Compute Step 3: Relever
cyclicality and operating leverage average of firms’ average unlevered
unlevered betas beta using Brocade’s
debt/equity ratio
Firm Levered Debt / Unlevered Beta2 Brocade’s
Beta1 Equity1 Relevered Beta3
EMC 1.62 .301 1.37 NA
Sandisk 1.44 .285 1.23 NA
Western Digital 1.51 .273 1.30 NA
NetApp Inc. 1.83 .254 1.59 NA
Terredata 1.12 .149 1.03 NA
Average = 1.30 1.50
2ß = ßl / (1 + (1-t) (D/E)), where ßu and ßl are unlevered and levered betas; marginal tax rate is .4. For
u
example, EMC (ßu ) = 1.62 / (1 + (1 - .4).301)) = 1.37
3ß = ßu (1 + (1-t) (D/E)) using Brocade’s debt/equity ratio of .256 and marginal tax rate of .4, Brocade’s
l
relevered beta = 1.30 (1 + (1 - .4).256)) = 1.50
 Beta of a Portfolio
•The beta of a portfolio is the weighted average of the beta
values of the individual securities in the portfolio.

 p  w11  w2  2  w3  3    wn  n

where wi is the proportion of value invested in security

i, and i is the beta of the security i. For two
securities, the portfolio beta is:

 p  w1 1  w2  2
 Security Amount Invested Expected Return Beta
A £1000 8 0.80
B 2000 12 0.95
C 3000 15 1.10
D 4000 18 1.40

What is the expected return on this portfolio? What is the beta of this portfolio? Does
this portfolio have more or less systematic risk than an average asset?

The weights of portfolio: A: 10% B 20% C 30% D 40%

The expected return:
E(RP ) = .10 x E(RA ) + .20 x E(RB) + .30 x E(RC) + .40 x E(RD)
= .10 x 8% + .20 x 12% + .30 x 15% + .40 x 18%
= 14.9%
The portfolio beta, P, is:
P = .10 x A + .20 x B + .30 xC + .40 x D
= .10 x .80 + .20 x .95 + .30 x 1.10 + .40 x 1.40
= 1.16
This portfolio thus has an expected return of 14.9 percent and a beta of 1.16. Because the beta is
larger than 1, this portfolio has greater systematic risk than an average asset.
 Example
• Suppose the risk premium on the market
portfolio is estimated at 8% with standard
deviation of 22%. What is the risk premium on
a portfolio invested 25% in MUL and 75% in
Tata Motors, if they have betas of 1.10 and
1.25, respectively?
 Graphical Representation of the
Security Market Line
ri  r f   i ( RM  r f )

ri  r f  2( RM  r f )
Risk
Premium
M for a stock
rM twice as
Market
1 Risk risky as
ri  r f  ( RM  r f ) the market
2 Premium
rf
Risk Premium for a
Riskless
stock half as risky
return
as the market

0.5 1.0 2.0
 Important Property of SML
• If an asset has a [beta/expected return] combination on the
SML, the asset is fairly priced.
• If the [beta/expected return] combination of an asset is
above the SML, the asset is underpriced (has a high return
for its beta).
• If the [beta/expected return] combination of an asset is
below the SML, the asset is overpriced (has a low return for
its beta).
• Competition among investors will tend to force stocks’
[beta/expected returns] towards the SML.
 SML
Return

30
SML

20 Forces

10
Market
Portfolio
0
Beta
1.0
 Alpha
• The difference between the actual and fair
values of a stock is called alpha, denoted by α
• E.g. if expected market return is 14%, Rf is 6%,
and a stock has a beta of 1.2. The stock is
believed to provide an expected return of
17%. What is α?
The SML and a Positive-Alpha Stock
 Example
• If Risk free rate is 7%, Rm is 15% and following
information is given. Determine whether each
stock is undervalued, overvalued or properly
valued, and outline an appropriate trading
strategy.
Stock Actual Return (%) Expected Return Beta
(%)

A 12 15 1
B 17.5 13.4 .8
C 16.6 16.6 1.2
 Risk Adjusted Performance: Sharpe

1) Sharpe Index
(rP  rf )
P
rp = Average return on the portfolio
rf = Average risk free rate
p = Standard deviation of portfolio
return
 Limitation
• Total risk is considered when only systematic
risk is priced
• Ratio not informative
 Risk Adjusted Performance: Treynor

2) Treynor Measure
(rP  rf )
P
rp = Average return on the portfolio
rf = Average risk free rate
ßp = Weighted average for portfolio
 Risk Adjusted Performance: Jensen

3) Jensen’s Measure
 P  rP   rf   P (rM  rf ) 

p = Alpha for the portfolio

rp = Average return on the portfolio
ßp = Weighted average Beta
rf = Average risk free rate
rm = Average return on market index portfolio
 2
M Measure
• Developed by Modigliani and Modigliani
• Equates the volatility of the managed portfolio
with the market by creating a hypothetical
portfolio made up of T-bills and the managed
portfolio
• If the risk is lower than the market, leverage is
used and the hypothetical portfolio is
compared to the market
M 2  rP*  rM
 2
M Measure: Example
Managed Portfolio: return = 35% standard deviation = 42%
Market Portfolio: return = 28% standard deviation = 30%
T-bill return = 6%
Hypothetical Portfolio:
30/42 = .714 in P (1-.714) or .286 in T-bills
(.714) (.35) + (.286) (.06) = 26.7%
Since this return is less than the market, the managed portfolio
underperformed
 2
M of Portfolio P
 M Sq measure
• Gives the ranking same as Sharpe Ratio
• But easier to interpret as they are in %
• If M sqr = 0
• If Msqr>0
• If Msqr<0
 Use of CAPM
• The model gives a precise prediction of the
relationship between the risk of an asset and
its expected return
• It provides a benchmark rate of return for
evaluating possible investments
• Useful in capital budgeting decisions, provides
required rate of return or hurdle rate
• It helps to make an educated guess of the
expected return on assets that have not yet
been traded in the market place e.g. IPOs
 Applying the CAPM
• The CML prescribes that investors should
invest in the riskless asset and the market
portfolio.
• The true market portfolio, which consists of all
risky assets, cannot be constructed.
• How much diversification is necessary to get
substantially “all” of the benefits of
diversification?
– About 25 to 30 stocks!
 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
– Assumptions are unrealistic
• CAPM is still considered the best available
description of security pricing and is widely
accepted
 Role and Validity of CAPM

• CAPM is based on some assumptions (e.g. borrowing

and lending rates are equal), and provides us an
estimate of the expected (required) return of an
investment (say, stock).
• It is an economic model of asset pricing with a
simplified statement of reality: few people quarrel
with the idea that investors require extra return for
taking risk.
• Empirical research with a long history of data shows
that:
– expected returns do increase with beta, though less
rapidly than the CAPM predicts.