ChapterNineTheCapitalAssetPricingModelCAPMisasetofpredictionsconcerningequilibriumexpectedreturnsonriskyassetsBasedontwosetsofassumptionsIndividualbehaviorMarketstructureMarkowitzestablishedmodernportfoliomanagementin1952Sharpe,LintnerandMossinpublishedCAPMin1964CapitalAssetPricingModel(CAPM)?2021McGraw-HillEducation9-2Assumptions?2021McGraw-HillEducation9-3Allinvestorswillholdthesameportfolioforriskyassets—marketportfolioMarketportfoliocontainsallsecuritiesProportionofeachstockinthisportfolioequalsthemarketvalueofthestock(pricepersharetimesnumberofsharesoutstanding)dividedbythesumofthemarketvalueofallstocksTheMarketPortfolio?2021McGraw-HillEducation9-4CapitalAllocationLine?2021McGraw-HillEducation9-5CapitalMarketLine?2021McGraw-HillEducation9-6Themarketriskpremiumisproportionaltoitsriskandthedegreeofriskaversion:

Whererepresentativeinvestor’sriskaversionvarianceofthemarketportfolioTheRiskPremiumoftheMarketPortfolio?2021McGraw-HillEducation9-7CAPMisbuildontheinsightthattheappropriateriskpremiumonanassetwillbedeterminedbyitscontributiontotheriskofinvestors’overallportfoliosAllinvestorsusethesameinputlist(i.e.,theyallendupusingthemarketastheiroptimalriskyportfolio)ExpectedReturnsonIndividualSecurities?2021McGraw-HillEducation9-8CovarianceofGEreturnwiththemarketportfolio:Thereward-to-riskratioforGEwouldbe:IndividualSecurities:

Example?2021McGraw-HillEducation9-9Reward-to-riskratioforinvestmentinmarketportfolio(i.e.,marketpriceofrisk):Equilibriumdictatesallinvestmentsshouldofferthesamereward-to-riskratioGEExample

(1of2)?2021McGraw-HillEducation9-10FairriskpremiumforGEstock:Restating,weobtain:GEExample

(2of2)?2021McGraw-HillEducation9-11Expectedreturn-betarelationshiptellsusthetotalexpectedrateofreturnisthesumoftherisk-freerateplusariskpremiumRiskpremiumistheproductofa“benchmarkriskpremium”andtherelativeriskoftheparticularassetasmeasuredbyitsbetaExpectedReturn-BetaRelationship?2021McGraw-HillEducation9-12TheSecurityMarketLine?2021McGraw-HillEducation9-13TheSMLandaPositive-AlphaStock?2021McGraw-HillEducation9-14Indexmodelstatestherealizedexcessreturnonanystockisthesumofthefollowing:RealizedexcessreturnduetomarketwidefactorsAnonmarketpremiumFirm-specificoutcomesTheindexmodelbetacoefficientisthesameasthebetaoftheCAPMexpectedreturn-betarelationshipTheCAPMandtheSingle-IndexMarket?2021McGraw-HillEducation9-15FundamentaldistinctionbetweensystematicanddiversifiableriskremainsineachvariantofthebasicmodelCAPMisbuildon“uncomfortablyrestrictive”assumptionsSeeassumptionfromTable9.1AssumptionsandExtensionsoftheCAPM?2021McGraw-HillEducationIdenticalInputListsIntheabsenceofprivateinformation,investorsshouldassumealphavaluesarezeroZero-BetaModelHelpstoexplainpositivealphasonlowbetastocksandnegativealphasonhighbetastocksLaborIncomeandOtherNontradedAssetsManyassetsarenottradeable(e.g.,privatebusinesses,humancapital,earningpowerofindividuals,etc.)ExtensionsoftheCAPM

(1of3)?2021McGraw-HillEducation9-17MultiperiodModelandHedgePortfoliosInvestorsshouldbemoreconcernedwiththestreamofconsumptionthatwealthcanbuyforthemConsumption-BasedCAPM(CCAPM)Rubinstein,Lucas,andBreedenInvestorsallocatewealthbetweenconsumptiontodayandinvestmentforthefutureExtensionsoftheCAPM

(2of3)?2021McGraw-HillEducation9-18LiquidityFinancialcostsinhibittradesLiquidityofanassetistheeaseandspeedwithwhichitcanbesoldatfairmarketvalueIlliquiditycanbemeasuredinpartbythediscountfromfairmarketvalueasellermustacceptiftheassetistobesoldquicklyExtensionsoftheCAPM

(3of3)?2021McGraw-HillEducation9-19TheRelationshipBetween

IlliquidityandAverageReturns?2021McGraw-HillEducation9-20Inafinancialcrisis,liquiditycanunexpectedlydryupWhenliquidityinonestockdecreases,itcommonlytendstodecreaseinotherstocksatthesametimeInvestorsdemandcompensationforliquidityrisk,demonstratedbyfirmswithgreaterliquidityriskhavinghigheraveragereturns“Liquiditybetas”LiquidityRisk?2021McGraw-HillEducation9-21TestingtheCAPMissurprisinglydifficultCannotobservealltradableassetsImpossibletopindownmarketportfolioBothalphaandbeta,aswellasresidualvariance,arelikelytimevaryingMosttestsoftheCAPMaredirectedatthemean-betarelationshipasappliedtoassetswithrespecttoanobserved,butperhapsinefficient,stockindexportfolioTheCAPMandAcademicWorld?2021McGraw-HillEducation9-22Portfoliotheorya