Ross 7 e CH 10

10-0
CHAPTER
10
The Capital Asset Pricing
Model (CAPM)
McGraw-Hill/Irwin
Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
10-1
Chapter Outline
10.1 Individual Securities
10.2 Expected Return, Variance, and Covariance
10.3 The Return and Risk for Portfolios
10.4 The Efficient Set for Two Assets
10.5 The Efficient Set for Many Securities
10.6 Diversification: An Example
10.7 Riskless Borrowing and Lending
10.8 Market Equilibrium
10.9 Relationship between Risk and Expected Return
(CAPM)
10.10 Summary and Conclusions
McGraw-Hill/Irwin
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10.1 Individual Securities

The characteristics of individual securities that
are of interest are the:
Expected Return
Variance and Standard Deviation
Covariance and Correlation
McGraw-Hill/Irwin
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10.2 Expected Return, Variance,

and Covariance
Rate of Return
Scenario Probability Stock fund Bond fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%
Consider the following two risky asset world.

There is a 1/3 chance of each state of the
economy and the only assets are a stock fund and
a bond fund.
McGraw-Hill/Irwin
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and Covariance
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
McGraw-Hill/Irwin
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and Covariance
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
E (rS ) = 1 ( -7%) + 1 (12%) + 1 (28%)

3 3 3
E (rS ) = 11%
McGraw-Hill/Irwin
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and Covariance
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
E (rB ) = 1 (17%) + 1 (7%) + 1 ( -3%)

3 3 3
E (rB ) = 7%
McGraw-Hill/Irwin
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and Covariance
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
(11% 7%) = 3.24%

- - 2
McGraw-Hill/Irwin
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and Covariance
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
(11% 12%) = .01%

- 2
McGraw-Hill/Irwin
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and Covariance
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
(11% 28%) = 2.89%

- 2
McGraw-Hill/Irwin
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and Covariance
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
1
2.05% = (3.24% + 0.01% + 2.89%)
3
McGraw-Hill/Irwin
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and Covariance
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
14.3% = 0.0205
McGraw-Hill/Irwin
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10.3 The Return and Risk

for Portfolios
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
Note that stocks have a higher expected return than bonds and
higher risk. Let us turn now to the risk-return tradeoff of a portfolio
that is 50% invested in bonds and 50% invested in stocks.
McGraw-Hill/Irwin
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Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
The rate of return on the portfolio is a weighted average of the

returns on the stocks and bonds in the portfolio:
rP = wB rB + wS rS
5% = 50% (-7%) + 50% (17%)
McGraw-Hill/Irwin
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Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010

rP = wB rB + wS rS
9.5% = 50% (12%) + 50% (7%)

McGraw-Hill/Irwin
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Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010

rP = wB rB + wS rS
12.5% = 50% (28%) + 50% ( -3%)
McGraw-Hill/Irwin
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Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010
The expected rate of return on the portfolio is a weighted average

of the expected returns on the securities in the portfolio.
E (rP ) = wB E (rB ) + wS E (rS )
9% = 50% (11%) + 50% (7%)
McGraw-Hill/Irwin
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Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010
The variance of the rate of return on the two risky assets portfolio is
=2
P(wB B ) (wS S ) + 2(wB B )(wS S )BS
2
+ 2
where BS is the correlation coefficient between the returns on the

stock and bond funds.
McGraw-Hill/Irwin
10-18

Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010
Observe the decrease in risk that diversification offers.

An equally weighted portfolio (50% in stocks and 50% in bonds)
has less risk than stocks or bonds held in isolation.
McGraw-Hill/Irwin
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% in stocks Risk Return
0% 8.2% 7.0%
Portfolo Risk and Return Combinations
Portfolio Return
5% 7.0% 7.2%
10% 5.9% 7.4%
12.0%
15% 4.8% 7.6%
11.0%
20% 3.7% 7.8%
10.0% 100%
25% 2.6% 8.0%
9.0% stocks
30% 1.4% 8.2%
35% 0.4% 8.4% 8.0%
40% 0.9% 8.6% 7.0% 100%
45% 2.0% 8.8% 6.0% bonds
50.00% 3.08% 9.00% 5.0%
55% 4.2% 9.2% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
60% 5.3% 9.4%
65% 6.4% 9.6%
Portfolio Risk (standard deviation)
70% 7.6% 9.8%
75% 8.7% 10.0% We can consider other
80% 9.8% 10.2%
85% 10.9% 10.4%
portfolio weights besides
90% 12.1% 10.6% 50% in stocks and 50% in
95%
100%
13.2%
14.3%
10.8%
11.0%
bonds
McGraw-Hill/Irwin
10-20

% in stocks Risk Return
0%
0% 8.2%
8.2% 7.0%
7.0%
Portfolo Risk and Return Combinations
Portfolio Return
5%
5% 7.0%
7.0% 7.2%
7.2%
10%
10% 5.9%
5.9% 7.4%
7.4%
12.0%
15%
15% 4.8%
4.8% 7.6%
7.6%
11.0%
20%
20% 3.7%
3.7% 7.8%
7.8%
10.0% 100%
25%
25% 2.6%
2.6% 8.0%
8.0%
9.0% stocks
30%
30% 1.4%
1.4% 8.2%
8.2%
35%
35% 0.4%
0.4% 8.4%
8.4% 8.0%
7.0%
40%
40% 0.9%
0.9% 8.6%
8.6% 100%
45%
45% 2.0%
2.0% 8.8%
8.8% 6.0%
bonds
50%
50% 3.1%
3.1% 9.0%
9.0% 5.0%
55%
55% 4.2%
4.2% 9.2%
9.2% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
60%
60% 5.3%
5.3% 9.4%
9.4%
65%
65% 6.4%
6.4% 9.6%
9.6%
Portfolio Risk (standard deviation)
70%
70% 7.6%
7.6% 9.8%
9.8%
75%
75% 8.7%
8.7% 10.0%
10.0% We can consider other
80%
80% 9.8%
9.8% 10.2%
10.2%
85%
85% 10.9%
10.9% 10.4%
10.4%
portfolio weights besides
90%
90% 12.1%
12.1% 10.6%
10.6% 50% in stocks and 50% in
95%
95%
100%
100%
13.2%
13.2%
14.3%
14.3%
10.8%
10.8%
11.0%
11.0%
bonds
McGraw-Hill/Irwin
10-21

% in stocks Risk Return Portfolo Risk and Return Combinations
Portfolio Return
0% 8.2% 7.0%
5% 7.0% 7.2% 12.0%
10% 5.9% 7.4% 11.0%
15% 4.8% 7.6% 10.0%
20% 3.7% 7.8% 9.0% 100%
25% 2.6% 8.0% 8.0% stocks
30% 1.4% 8.2% 7.0%
35% 0.4% 8.4%
6.0%
40% 0.9% 8.6% 100%
5.0%
45% 2.0% 8.8% bonds
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
50% 3.1% 9.0%
55% 4.2% 9.2% Portfolio Risk (standard deviation)
60% 5.3% 9.4%
65% 6.4% 9.6% Note that some portfolios are
70% 7.6% 9.8%
75% 8.7% 10.0% better than others. They have
80% 9.8% 10.2% higher returns for the same level of
85% 10.9% 10.4%
90% 12.1% 10.6% risk or less. These compromise the
95% 13.2% 10.8%
100% 14.3% 11.0% efficient frontier.
McGraw-Hill/Irwin
10-22
Two-Security Portfolios with Various Correlations
return
100%
= -1.0 stocks
= 1.0
100%
= 0.2
bonds

Relationship depends on correlation coefficient
-1.0 < < +1.0
If = +1.0, no risk reduction is possible
If = 1.0, complete risk reduction is possible
McGraw-Hill/Irwin
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Portfolio Risk as a Function of the Number of Stocks

in the Portfolio
In a large portfolio the variance terms are effectively
diversified away, but the covariance terms are not.
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
Thus diversification can eliminate some, n
but not all of the risk of individual securities.
McGraw-Hill/Irwin
10-24
return
Individual Assets
P
Consider a world with many risky assets; we can still
identify the opportunity set of risk-return combinations
of various portfolios.
McGraw-Hill/Irwin
10-25
return
minimum
variance
portfolio
Individual Assets
P
Given the opportunity set we can identify the
minimum variance portfolio.
McGraw-Hill/Irwin
10-26
return
minimum
variance
portfolio
Individual Assets
P
The section of the opportunity set above the minimum
variance portfolio is the efficient frontier.
McGraw-Hill/Irwin
10-27
Optimal Risky Portfolio with a Risk-Free Asset
return 100%
stocks
rf
100%
bonds

In addition to stocks and bonds, consider a world
that also has risk-free securities like T-bills
McGraw-Hill/Irwin
10-28
return 100%
stocks
Balanced
fund
rf
100%
bonds

Now investors can allocate their money across the
T-bills and a balanced mutual fund
McGraw-Hill/Irwin
10-29
return
rf
P
With a risk-free asset available and the efficient frontier
identified, we choose the capital allocation line with the
steepest slope
McGraw-Hill/Irwin
10-30
10.8 Market Equilibrium
return
rf
P
With the capital allocation line identified, all investors choose a point along the
linesome combination of the risk-free asset and the market portfolio M. In a
world with homogeneous expectations, M is the same for all investors.
McGraw-Hill/Irwin
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The Separation Property
return
rf
P
The Separation Property states that the market portfolio, M, is the
same for all investorsthey can separate their risk aversion from
their choice of the market portfolio.
McGraw-Hill/Irwin
10-32
return
rf
P
Investor risk aversion is revealed in their choice of where to stay
along the capital allocation linenot in their choice of the line.
McGraw-Hill/Irwin
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Market Equilibrium
return 100%
stocks
Balanced
fund
rf
100%
bonds

Just where the investor chooses along the Capital Asset Line depends
on his risk tolerance. The big point though is that all investors
have the same CML.
McGraw-Hill/Irwin
10-34
Market Equilibrium
return 100%
stocks
Optimal
Risky
Portfolio
rf
100%
bonds

All investors have the same CML because they all have the
same optimal risky portfolio given the risk-free rate.
McGraw-Hill/Irwin
10-35
return
100%
stocks
Optimal
Risky
Portfolio
rf
100%
bonds

The separation property implies that portfolio choice can be
separated into two tasks: (1) determine the optimal risky portfolio,
and (2) selecting a point on the CML.
McGraw-Hill/Irwin
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Optimal Risky Portfolio with a Risk-Free Asset
return
100%
stocks
1 First Second Optimal

rf Optimal Risky Portfolio
0 Risky
rf
Portfolio
100%
bonds

By the way, the optimal risky portfolio depends on
the risk-free rate as well as the risky assets.
McGraw-Hill/Irwin
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Definition of Risk When Investors Hold

the Market Portfolio
Researchers have shown that the best measure of
the risk of a security in a large portfolio is the
beta (b)of the security.
Beta measures the responsiveness of a security to
movements in the market portfolio.
Cov ( Ri , RM )
bi =
( RM )
2
McGraw-Hill/Irwin
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Estimating b with regression
Security Returns
Slope = bi
Return on
market %
Ri = a i + biRm + ei
McGraw-Hill/Irwin
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Estimates of b for Selected Stocks

Stock Beta
Bank of America 1.55
Borland International 2.35
Travelers, Inc. 1.65
Du Pont 1.00
Kimberly-Clark Corp. 0.90
Microsoft 1.05
Green Mountain 0.55
Power
Homestake Mining 0.20
Oracle, Inc. 0.49
McGraw-Hill/Irwin
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The Formula for Beta
Cov ( Ri , RM )
bi =
2 ( RM )
Clearly, your estimate of beta will depend upon your

choice of a proxy for the market portfolio.
McGraw-Hill/Irwin
10-41
10.9 Relationship between Risk

and Expected Return (CAPM)
Expected Return on the Market:

R M = RF + Market Risk Premium
Expected return on an individual security:
Ri = RF + i ( R M - RF )
Market Risk Premium

This applies to individual securities held within well-
diversified portfolios.
McGraw-Hill/Irwin
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Expected Return on an Individual Security
This formula is called the Capital Asset Pricing

Model (CAPM)
Ri = RF + i ( RM - RF )
Expected
Risk- Beta of the Market risk
return on = +
free rate security premium
a security
Assume bi = 0, then the expected return is RF.

Assume bi = 1, then Ri = RM
McGraw-Hill/Irwin
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Relationship Between Risk & Expected Return
Expected return
Ri = RF + i ( RM - RF )
RM
RF
1.0 b
McGraw-Hill/Irwin
10-44
Relationship Between Risk & Expected Return
Expected
return
13.5%
3%
1.5 b
i = 1.5 RF = 3% RM =10%
R i = 3% + 1.5 (10% - 3%) = 13.5%
McGraw-Hill/Irwin
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This chapter sets forth the principles of modern portfolio theory.
The expected return and variance on a portfolio of two securities
A and B are given by
E (rP ) = wA E (rA ) + wB E (rB )
P2 = (wA A )2 +(wB B )2 + 2(wB B )(wA A )AB

By varying wA, one can trace out the efficient set of portfolios.
We graphed the efficient set for the two-asset case as a curve,
pointing out that the degree of curvature reflects the
diversification effect: the lower the correlation between the two
securities, the greater the diversification.
The same general shape holds in a world of many assets.
McGraw-Hill/Irwin
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The efficient set of risky assets can be combined with riskless
borrowing and lending. In this case, a rational investor will
always choose to hold the portfolio of risky securities represented
by the market portfolio.
Then with borrowing return

or lending, the M
investor selects a point
along the CML.
rf
P
McGraw-Hill/Irwin
10-47

The contribution of a security to the risk of a well-diversified
portfolio is proportional to the covariance of the security's return
with the markets return. This contribution is called the beta.
Cov( Ri , RM )
bi =
2 ( RM )
The CAPM states that the expected return on a security is
positively related to the securitys beta:
Ri = RF + i ( RM - RF )
McGraw-Hill/Irwin

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10-0

10.1 Individual Securities

10.2 Expected Return, Variance,

Consider the following two risky asset world.

10.2 Expected Return, Variance,

10.2 Expected Return, Variance,

E (rS ) = 1 ( -7%) + 1 (12%) + 1 (28%)

10.2 Expected Return, Variance,

E (rB ) = 1 (17%) + 1 (7%) + 1 ( -3%)

10.2 Expected Return, Variance,

(11% 7%) = 3.24%

10.2 Expected Return, Variance,

(11% 12%) = .01%

10.2 Expected Return, Variance,

(11% 28%) = 2.89%

10.2 Expected Return, Variance,

10.2 Expected Return, Variance,

10.3 The Return and Risk

10.3 The Return and Risk for Portfolios

Expected return 11.00% 7.00% 9.0%

The rate of return on the portfolio is a weighted average of the

10.3 The Return and Risk for Portfolios

Expected return 11.00% 7.00% 9.0%

The rate of return on the portfolio is a weighted average of the

9.5% = 50% (12%) + 50% (7%)

10.3 The Return and Risk for Portfolios

Expected return 11.00% 7.00% 9.0%

The rate of return on the portfolio is a weighted average of the

10.3 The Return and Risk for Portfolios

Expected return 11.00% 7.00% 9.0%

The expected rate of return on the portfolio is a weighted average

10.3 The Return and Risk for Portfolios

Expected return 11.00% 7.00% 9.0%

where BS is the correlation coefficient between the returns on the

10.3 The Return and Risk for Portfolios

Expected return 11.00% 7.00% 9.0%

Observe the decrease in risk that diversification offers.

10.4 The Efficient Set for Two Assets

10.4 The Efficient Set for Two Assets

10.4 The Efficient Set for Two Assets

Two-Security Portfolios with Various Correlations

Portfolio Risk as a Function of the Number of Stocks

10.5 The Efficient Set for Many Securities

10.5 The Efficient Set for Many Securities

10.5 The Efficient Set for Many Securities

Optimal Risky Portfolio with a Risk-Free Asset

10.7 Riskless Borrowing and Lending

10.7 Riskless Borrowing and Lending

10.8 Market Equilibrium

The Separation Property

The Separation Property

The Separation Property

Optimal Risky Portfolio with a Risk-Free Asset

1 First Second Optimal

Definition of Risk When Investors Hold

Estimating b with regression

Estimates of b for Selected Stocks

The Formula for Beta

Clearly, your estimate of beta will depend upon your

10.9 Relationship between Risk

Expected Return on the Market:

Market Risk Premium

Expected Return on an Individual Security