Introduction to

Asset Pricing Models

Capital Asset Pricing Model
Introduction to Asset Pricing Models 2
Model to price all risky assets based on existing portfolio
theory (e.g. Risk Aversion, Return Maximization)
Gives the required rate of return for any given risky asset.
Assumptions
Introduction to Asset Pricing Models 3
All investors are Markowitz Efficient Investors.
All investors can borrow or lend at the risk free rate.
All investors have homogenous expectations.
All investors have the same investment time horizon.
All investments are infinitely divisible.
No tax and transaction costs in buy/sell.
No inflation or change in interest rates.
Capital markets are in equilibrium.
Risk Free Asset
Introduction to Asset Pricing Models 4
Risky Asset = Asset with uncertain returns.
Risk-Free Asset = Asset with = 0
Thus, for any investment, minimum return should be at least
equal to the risk-free rate.
In modelling, this is usually the 365-day T-Bill rate.
Risk-Free Asset in a Risky Portfolio
Introduction to Asset Pricing Models 5
Expected Return
Standard Deviation

+ 1

)
= (

)
2
+(

)
2
+2

= (

)
2
+[(1

]
2
+2

= [(1

]
2
= (1

= 0,
Risk-Free Asset in a Risky Portfolio
Introduction to Asset Pricing Models 6
Linear combinations of risk-free and risky asset portfolio.
Point M = point of tangency with portfolio M.

= 0 + 1

= (

=
1
2
+
1
2
(

)
Risk-Free Asset in a Risky Portfolio
Introduction to Asset Pricing Models 7
What if you want a return higher than M ?
Higher than D, but with
the same level of risk.

= 0.5 + [1 0.5 ](

= 0.5 + 1.5(

)
Risk-Free Asset in a Risky Portfolio
Introduction to Asset Pricing Models 8
New efficient frontier = Capital Market Line (CML)
Market Portfolio
Introduction to Asset Pricing Models 9
Includes all risky assets - Completely Diversified Portfolio
Stocks Local and International
Bonds
Options
Real Estate
Physical Assets antiques, coins, gold, art, etc.
Complete Diversification takes away all unsystematic
(diversifiable and unique) risk.
Systematic Risk = caused by macroeconomic variables.
All assets are in proportion to their market value.
Security Market Line (SML)
Introduction to Asset Pricing Models 10
Given that the Market Portfolio is the ideal and completely
diversified portfolio, an individual assets risk can be attributed
to its variability, or covariance, with the market portfolio.
If asset is riskier than market portfolio, then a higher return is expected.
If asset is less risky than market portfolio, lower return is expected.
Capital Asset Pricing Model (CAPM)
Introduction to Asset Pricing Models 11
Beta standardized measure of systematic risk.
1 = perfectly correlated with the market portfolio.
> 1 = more volatile than market portfolio.
< 1 = less volatile than market portfolio.

= +

2

,

= +

2
(

= + (

)
Required vs Estimated Returns
Introduction to Asset Pricing Models 12
Required ideal return given level of risk as indicated by
CAPM Model.
If RFR = 6% and Market Rate of Return = 12%, compute for
the required returns of each stock and determine whether
the stock is properly, under, or over valued.
Stock Beta Estimated Return
A 0.70 10.0%
B 1.00 6.2%
C 1.15 21.2%
D 1.40 3.3%
E -0.30 8.0%