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Principles of Corporate Finance, 14th

Edition
Chapter 8: Portfolio Theory and The Capital Asset Pricing
Model
Brealey, Myers, Allen, and Edmans

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
 Topics Covered
Market Risk Is Measured by Beta.
The Relationship Between Risk and Return.
Does the CAPM Hold in the Real World?
Some Alternative Theories.

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 Market Risk Is Measured by Beta
Market Portfolio: Portfolio of all assets in the economy. In
practice, a broad stock market index such as the S&P
Composite is used to represent the market.
Beta: Sensitivity of a stock’s return to the return on the
market portfolio.

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 Portfolio Risk, Beta

σ im
βi  2
σm

σim Covariance between the

stock i returns and the
market returns.

2
σ m Variance of the returns
on the market.

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 Figure 8.1 The Return on Amazon Stock

The return on Amazon stock changes on average by 1.55% for

each 1.00% change in the market return. Beta is therefore 1.55.
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 Table 8.1 Estimated Betas for Select U.S. Stocks.

Stock Beta (β)

United States Steel 2.98
Southwest Airlines 1.58
Amazon 1.55
Wells Fargo 1.14
ExxonMobil 1.14
Johnson & Johnson 0.75
Tesla 0.50
Coca-Cola 0.46
Consolidated Edison 0.31
Newmont 0.16

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 Table 8.3 Portfolio Risk, Beta 1

Calculating the variance of the market returns and the covariance between
the returns on the market and those of Anchovy Queen. Beta is the ratio of

the variance to the covariance i.e., β  σ im /σ m .
2

(1) (2) (3) (4) (5) (6) (7)
Squared Deviation Product of
Deviation from Deviation from
Market Company from Average Deviations from
Month Average Market Average
Return Return Market Return Average Returns
Return Company Return
(Columns 4×4) (Columns 4×5)
1 −8% −11% −10 −10 100 130

2 4 8 2 6 4 12

3 12 19 10 17 100 170

4 −6 −13 −8 −15 64 120

5 2 3 0 1 0 0

6 8 6 6 4 36 24

Average 2 2 Total 304 456

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 Table 8.3 Portfolio Risk, Beta 2

Variance  σ 2m  304 / 6  50.67

Covariance  σim  456 / 6  76

Beta (β)   im /  m2  76 / 50.67  1.5

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 Why Betas Determine Portfolio Risk
• Risk in a well-diversified portfolio is given by its market
risk.
• Market Risk is measured by beta.

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 Figure 8.2 Portfolio Risk, Beta

Green line: Well-diversified portfolio of randomly selected stocks with β  1 and σ

= 20% (market risk).
Red line: Well-diversified portfolio with β  1.5 and σ  30% (1.5 times market risk).

Blue line: Well-diversified portfolio with β  0.5 has σ  10% (half that of the market).
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 Capital Asset Pricing Model

ri  rf   i   rm  rf 

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 Figure 8.3 Capital Asset Pricing Model

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 Figure 8.4 Equilibrium
In equilibrium, no stock lies below the security market line.
Instead of buying Stock A, investors lend part of their money
and put the balance in the market portfolio. Instead of buying
Stock B, they borrow and invest in the market portfolio.

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 Table 8.4 Expected Returns
These estimates of the returns expected by investors in December 2020 were based
on the CAPM. We assumed rf  2% and 7% for the expected risk premium, rm  rf .

Stock Beta (β) Expected Return

United States Steel 2.98 22.9
Southwest Airlines 1.58 13.0
Amazon 1.55 12.8
Wells Fargo 1.14 10.0
ExxonMobil 1.14 10.0
Johnson & Johnson 0.75 7.3
Tesla 0.50 5.5
Coca-Cola 0.46 5.2
Consolidated Edison 0.31 4.1
Newmont 0.16 3.1

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 Does CAPM Hold in the Real World 1

The CAPM makes several assumptions:

1. Investors choose portfolios based on expected return and
variance (risk).
2. All investors have the same estimates of mean returns,
variances, and covariances.
3. Investors trade in perfect capital markets.
• no Taxes.
• no Transaction Costs.
• no restrictions on Short Sales.
• can borrow and Lend at the same risk-free rate.

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 Does CAPM Hold in the Real World 2

4. Investors are price takers.

5. The supply of all assets is fixed.

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 Figure 8.5 CAPM (1931–2020)
Beta Versus Average Risk Premium.

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 Figure 8.6 Relationship Between Beta and Average Return
(mid-1960s)

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 Figure 8.6 Relationship Between Beta and Average Return (19
66–2020)

Source: F. Black, “Beta and Return,” Journal of Portfolio Management 20 (Fall 1993), pp.
8–18. Updates courtesy of Adam Kolasinski.

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 Figure 8.7 Return Versus Book-to-Market

http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

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 Arbitrage Pricing Theory
Alternative to CAPM

Return  a  b1  rfactor1   b 2  rfactor 2   b3  rfactor3   ....  noise

Expected risk premium  r  rf

 b1  rfactor1  rf   b 2  rfactor 2  rf  

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 Three-Factor Model 1

Steps to Identify Factors.

1. Identify a reasonably short list of macroeconomic factors
that could affect stock returns.
2. Estimate the expected risk premium on each of these
factors  rfactor1  rf , etc..
3. Measure the sensitivity of each stock to the factors
b1 , b2 , etc..

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 Three-Factor Model 2

Factor Measured by
Market factor Return on market index minus risk-free interest rate
Size factor Return on small-firm stocks less return on large-firm
stocks
Book-to-market factor Return on high book-to-market-ratio stocks less return
on low book-to-market-ratio stocks

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 Table 8.5 Estimates of Expected Equity
Returns Using Three-Factor Model and C APM
Three-Factor Model

Factor Sensitivities CAPM

B
market B
size B
book-to-market Expected Return a Expected Return b
Autos 1.12 0.26 0.31 11.9% 10.2%
Banks 1.18 0.09 0.65 13.1 10.5
Chemicals 1.19 0.26 0.41 12.8 10.7
Computers 1.30 −0.18 0.03 10.5 10.9
Construction 0.96 0.49 0.04 10.4 9.3
Food 0.67 −0.38 0.02 5.6 6.3
Oil and gas 1.17 0.49 0.90 15.3 11.0
Pharmaceuticals 0.91 0.20 −0.38 7.5 8.5
Telecoms 0.78 −0.24 0.12 7.2 7.2
Utilities 0.46 −0.36 −0.08 3.7 4.8

A
The expected return equals the risk-free interest rate plus the factor sensitivities multiplied by the factor risk premiums, that is,

2.0  bmarket  7.0   bsize  3.1  bbook-to-market4.0 .

b
 
Estimated as rf  β rm  rf , that is, rf  β  7.0. Note that we used simple regression to estimate β in the CAPM
formula. This beta may, therefore, be different from bmarket
that we estimated from a multiple regression of stock returns
on the three factors.
Source: The industry indexes are value-weighted indexes from Kenneth French’s website,
mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.xhtml.
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