Capital Asset Pricing Mode1
Capital Asset Pricing Mode1
An estimation of the CAPM and the Security Market Line (purple) for the Dow Jones Industrial
Average over the last 3 years for monthly data.
In finance, the capital asset pricing model (CAPM) is used to determine a theoretically
appropriate required rate of return of an asset, if that asset is to be added to an already well-
diversified portfolio, given that asset's non-diversifiable risk. The model takes into account the
asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often
represented by the quantity beta (β) in the financial industry, as well as the expected return of the
market and the expected return of a theoretical risk-free asset.
The model was introduced by Jack Treynor (1961, 1962),[1] William Sharpe (1964), John Lintner
(1965a,b) and Jan Mossin (1966) independently, building on the earlier work of Harry
Markowitz on diversification and modern portfolio theory. Sharpe, Markowitz and Merton
Miller jointly received the Nobel Memorial Prize in Economics for this contribution to the field
of financial economics.
Contents
[hide]
1 The formula
2 Security market line
3 Asset pricing
4 Asset-specific required return
5 Risk and diversification
6 The efficient frontier
7 The market portfolio
8 Assumptions of CAPM
9 Shortcomings of CAPM
10 See also
11 References
12 Bibliography
13 External links
The Security Market Line, seen here in a graph, describes a relation between the beta and the
asset's expected rate of return.
The CAPM is a model for pricing an individual security or a portfolio. For individual securities,
we make use of the security market line (SML) and its relation to expected return and systematic
risk (beta) to show how the market must price individual securities in relation to their security
risk class. The SML enables us to calculate the reward-to-risk ratio for any security in relation to
that of the overall market. Therefore, when the expected rate of return for any security is deflated
by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal
to the market reward-to-risk ratio, thus:
The market reward-to-risk ratio is effectively the market risk premium and by rearranging the
above equation and solving for E(Ri), we obtain the Capital Asset Pricing Model (CAPM).
where:
which states that the individual risk premium equals the market premium times β.
Note 1: the expected market rate of return is usually estimated by measuring the Geometric
Average of the historical returns on a market portfolio (e.g. S&P 500).
Note 2: the risk free rate of return used for determining the risk premium is usually the arithmetic
average of historical risk free rates of return and not the current risk free rate of return.
The relationship between β and required return is plotted on the securities market line (SML)
which shows expected return as a function of β. The intercept is the nominal risk-free rate
available for the market, while the slope is the market premium, E(Rm)− Rf. The securities market
line can be regarded as representing a single-factor model of the asset price, where Beta is
exposure to changes in value of the Market. The equation of the SML is thus:
It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable
expected return for risk. Individual securities are plotted on the SML graph. If the security's
expected return versus risk is plotted above the SML, it is undervalued since the investor can
expect a greater return for the inherent risk. And a security plotted below the SML is overvalued
since the investor would be accepting less return for the amount of risk assumed.
In theory, therefore, an asset is correctly priced when its estimated price is the same as the
required rates of return calculated using the CAPM. If the estimate price is higher than the
CAPM valuation, then the asset is undervalued (and overvalued when the estimated price is
below the CAPM valuation).
Since beta reflects asset-specific sensitivity to non-diversifiable, i.e. market risk, the market as a
whole, by definition, has a beta of one. Stock market indices are frequently used as local proxies
for the market—and in that case (by definition) have a beta of one. An investor in a large,
diversified portfolio (such as a mutual fund), therefore, expects performance in line with the
market.
A rational investor should not take on any diversifiable risk, as only non-diversifiable risks are
rewarded within the scope of this model. Therefore, the required return on an asset, that is, the
return that compensates for risk taken, must be linked to its riskiness in a portfolio context - i.e.
its contribution to overall portfolio riskiness - as opposed to its "stand alone riskiness." In the
CAPM context, portfolio risk is represented by higher variance i.e. less predictability. In other
words the beta of the portfolio is the defining factor in rewarding the systematic exposure taken
by an investor.
The (Markowitz) efficient frontier. CAL stands for the capital allocation line.
The CAPM assumes that the risk-return profile of a portfolio can be optimized—an optimal
portfolio displays the lowest possible level of risk for its level of return. Additionally, since each
additional asset introduced into a portfolio further diversifies the portfolio, the optimal portfolio
must comprise every asset, (assuming no trading costs) with each asset value-weighted to
achieve the above (assuming that any asset is infinitely divisible). All such optimal portfolios,
i.e., one for each level of return, comprise the efficient frontier.
Because the unsystematic risk is diversifiable, the total risk of a portfolio can be viewed as beta.
For a given level of return, however, only one of these portfolios will be optimal (in the sense of
lowest risk). Since the risk free asset is, by definition, uncorrelated with any other asset, option 2
will generally have the lower variance and hence be the more efficient of the two.
This relationship also holds for portfolios along the efficient frontier: a higher return portfolio
plus cash is more efficient than a lower return portfolio alone for that lower level of return. For a
given risk free rate, there is only one optimal portfolio which can be combined with cash to
achieve the lowest level of risk for any possible return. This is the market portfolio.
All investors:
The model assumes that the probability beliefs of investors match the true distribution of
returns. A different possibility is that investors' expectations are biased, causing market
prices to be informationally inefficient. This possibility is studied in the field of
behavioral finance, which uses psychological assumptions to provide alternatives to the
CAPM such as the overconfidence-based asset pricing model of Kent Daniel, David
Hirshleifer, and Avanidhar Subrahmanyam (2001)[3].
The model does not appear to adequately explain the variation in stock returns. Empirical
studies show that low beta stocks may offer higher returns than the model would predict.
Some data to this effect was presented as early as a 1969 conference in Buffalo, New
York in a paper by Fischer Black, Michael Jensen, and Myron Scholes. Either that fact is
itself rational (which saves the efficient-market hypothesis but makes CAPM wrong), or
it is irrational (which saves CAPM, but makes the EMH wrong – indeed, this possibility
makes volatility arbitrage a strategy for reliably beating the market).[citation needed]
The model assumes that given a certain expected return investors will prefer lower risk
(lower variance) to higher risk and conversely given a certain level of risk will prefer
higher returns to lower ones. It does not allow for investors who will accept lower returns
for higher risk. Casino gamblers clearly pay for risk, and it is possible that some stock
traders will pay for risk as well.[citation needed]
The model assumes that there are no taxes or transaction costs, although this assumption
may be relaxed with more complicated versions of the model.[citation needed]
The market portfolio consists of all assets in all markets, where each asset is weighted by
its market capitalization. This assumes no preference between markets and assets for
individual investors, and that investors choose assets solely as a function of their risk-
return profile. It also assumes that all assets are infinitely divisible as to the amount
which may be held or transacted.[citation needed]
The market portfolio should in theory include all types of assets that are held by anyone
as an investment (including works of art, real estate, human capital...) In practice, such a
market portfolio is unobservable and people usually substitute a stock index as a proxy
for the true market portfolio. Unfortunately, it has been shown that this substitution is not
innocuous and can lead to false inferences as to the validity of the CAPM, and it has been
said that due to the inobservability of the true market portfolio, the CAPM might not be
empirically testable. This was presented in greater depth in a paper by Richard Roll in
1977, and is generally referred to as Roll's critique.[4]
The model assumes just two dates, so that there is no opportunity to consume and
rebalance portfolios repeatedly over time. The basic insights of the model are extended
and generalized in the intertemporal CAPM (ICAPM) of Robert Merton, and the
consumption CAPM (CCAPM) of Douglas Breeden and Mark Rubinstein.[citation needed]
CAPM assumes that all investors will consider all of their assets and optimize one
portfolio. This is in sharp contradiction with portfolios that are held by individual
investors: humans tend to have fragmented portfolios or, rather, multiple portfolios: for
each goal one portfolio — see behavioral portfolio theory [5] and Maslowian Portfolio
Theory [6].
[edit] References
1. ^ http://ssrn.com/abstract=447580
2. ^ Mandelbrot, B., and Hudson, R. L. (2004). The (Mis)Behaviour of Markets: A Fractal View of
Risk, Ruin, and Reward. London: Profile Books.
3. ^ 'Overconfidence, Arbitrage, and Equilibrium Asset Pricing,' Kent D. Daniel, David Hirshleifer
and Avanidhar Subrahmanyam, Journal of Finance, 56(3) (June, 2001), pp. 921-965
4. ^ 'ROLL, R. (1977): “A Critique of the Asset Pricing Theory’s Tests,” Journal of Financial
Economics, 4, 129–176.
5. ^ SHEFRIN, H., AND M. STATMAN (2000): “Behavioral Portfolio Theory,” Journal of
Financial and Quantitative Analysis, 35(2), 127–151.
6. ^ DE BROUWER, Ph. (2009): “Maslowian Portfolio Theory: An alternative formulation of the
Behavioural Portfolio Theory”, Journal of Asset Management, 9 (6), pp. 359–365.
[edit] Bibliography
Black, Fischer., Michael C. Jensen, and Myron Scholes (1972). The Capital Asset
Pricing Model: Some Empirical Tests, pp. 79–121 in M. Jensen ed., Studies in the Theory
of Capital Markets. New York: Praeger Publishers.
Fama, Eugene F. (1968). Risk, Return and Equilibrium: Some Clarifying Comments.
Journal of Finance Vol. 23, No. 1, pp. 29–40.
Fama, Eugene F. and Kenneth French (1992). The Cross-Section of Expected Stock
Returns. Journal of Finance, June 1992, 427-466.
French, Craig W. (2003). The Treynor Capital Asset Pricing Model, Journal of
Investment Management, Vol. 1, No. 2, pp. 60–72. Available at http://www.joim.com/
French, Craig W. (2002). Jack Treynor's 'Toward a Theory of Market Value of Risky
Assets' (December). Available at http://ssrn.com/abstract=628187
Lintner, John (1965). The valuation of risk assets and the selection of risky investments in
stock portfolios and capital budgets, Review of Economics and Statistics, 47 (1), 13-37.
Markowitz, Harry M. (1999). The early history of portfolio theory: 1600-1960, Financial
Analysts Journal, Vol. 55, No. 4
Mehrling, Perry (2005). Fischer Black and the Revolutionary Idea of Finance. Hoboken:
John Wiley & Sons, Inc.
Mossin, Jan. (1966). Equilibrium in a Capital Asset Market, Econometrica, Vol. 34, No.
4, pp. 768–783.
Ross, Stephen A. (1977). The Capital Asset Pricing Model (CAPM), Short-sale
Restrictions and Related Issues, Journal of Finance, 32 (177)
Rubinstein, Mark (2006). A History of the Theory of Investments. Hoboken: John Wiley
& Sons, Inc.
Sharpe, William F. (1964). Capital asset prices: A theory of market equilibrium under
conditions of risk, Journal of Finance, 19 (3), 425-442
Stone, Bernell K. (1970) Risk, Return, and Equilibrium: A General Single-Period Theory
of Asset Selection and Capital-Market Equilibrium. Cambridge: MIT Press.
Tobin, James (1958). Liquidity preference as behavior towards risk, The Review of
Economic Studies, 25
Treynor, Jack L. (1961). Market Value, Time, and Risk. Unpublished manuscript.
Treynor, Jack L. (1962). Toward a Theory of Market Value of Risky Assets. Unpublished
manuscript. A final version was published in 1999, in Asset Pricing and Portfolio
Performance: Models, Strategy and Performance Metrics. Robert A. Korajczyk (editor)
London: Risk Books, pp. 15–22.
Mullins, David W. (1982). Does the capital asset pricing