The capital asset pricing Model
CHAPTER OVERVIEW
This chapter presents the capital asset pricing model (CAPM), which is an equilibrium model for the pricing of assets based upon risk. This model rules out the possibility of arbitrage profits, that is, the exploitation of mispriced securities. The chapter begins with a simplified two-security example that develops the concept of demand for shares and how prices of securities would change with changes in demand. The presentation includes the assumptions that underlie the CAPM, major implications of model, and development of the Security Market Line. Extensions covered in the chapter include the zero beta model and incorporation of liquidity costs.
LEARNING OBJECTIVES
After studying this chapter, the student should be able to explain the theory of the capital asset pricing model (CAPM), and be able to construct and use the security market line. The student should also have a thorough understanding of the zero beta formulization and the impact that differential liquidity costs may have on expected return.
Presentation of Material
9.1 The Capital Asset Pricing Model
The introduction of the CAPM starts with an overview of the importance of the model and the assumptions that underlie it. The implications or conditions that result from the CAPM are described. Discussion of the equilibrium conditions that result from the model is very important before the analytical development of the CAPM.
Once the major implications and conditions have been discussed, the Capital Market Line can be derived. The market risk premium is displayed and The Capital Market Line (CML) is shown in Figure 9.1. In discussing the CML, it is helpful to tie in the concept of dominance covered in previous chapters. The conclusion that investors, regardless of their risk preferences, will combine the market portfolio with the risk free rate is an important topic to discuss.
Since the equilibrium conditions result in all investors holding the same portfolio of risky investments, pricing on individual securities is related to the risk that individual securities have when they are included in the market portfolio. The relevant measure of risk is the covariance of returns on the individual securities with the market portfolio.
Given that the relevant measure of risk is the risk that is related to the market portfolio, the Security Market Line (SML) describes that relationship. The slope of the SML is the market risk premium. The beta for the individual security is . When first examining these concepts, students often confuse the slope of the SML with the slope of the Security Characteristic Line. It is useful to spend class discussion time clarifying the differences in these relationships. The text considers GE as an example to help illustration these concepts.
9.2 Assumptions and Extensions of the CAPM
The assumptions used in the equilibrium model are explained using investor expectations. Notably, the CAPM would predict alpha values of zero for all securities. We find that alphas are not exactly zero as suggested by the model but the distribution of alpha’s show that they are distributed around a mean of zero. While the model fails empirical tests, CAPM has been widely accepted and fairly robust.
Liquidity is an important factor in determining prices and expected returns. Data show that variations in liquidity are systematic, affecting all stocks. Later studies demonstrate the relationship between greater liquidity levels and higher average returns.
A few other important extensions of the CAPM are presented in this section- Black’s Zero Beta Model, the incorporation of labor income and non-traded assets, and Merton’s Multi-period Model.
9.3The CAPM and the Academic World
Testing of the unobservable CAPM market portfolio is targeted at the mean-beta relationship with respect to a stock index portfolio. When assessing the empirical success of the CAPM, it is important to consider the econometric technique as demonstrated in a paper by Miller and Scholes. They considered a checklist of difficulties encountered in testing the model and showed how these problems potentially could bias conclusions.
9.4 The CAPM and the Investment Industry
Despite failing empirical tests, the industry continues to use the single-index CAPM model. Tests over time prove it extremely difficult to outperform the broad market portfolio, as is evidenced by the alpha distributions of mutual funds in figure 9.5. These observations validate the passive strategy the CAPM deems optimal.
9-1
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
(,)
()
im
m
Covrr
Varr
mloi01
IMChap009.docx
0
