McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Capital Asset Pricing and Arbitrage Pricing Theory CHAPTER 7

Chapter 7: Capital Asset Pricing Model (CAPM) CAPM is a theory of the relationship between __________ and ______________ CAPM underlies all modern finance Sharpe, Lintner and Mossin are credited with its development (especially Sharpe)

CAPM Assumptions Individual investors are price takers Investors are ______________________ Single-period investment horizon Investments are limited to traded financial assets No ______________________________ costs

CAPM Assumptions (cont.) Investors can borrow and lend at the ________________________rate Information is costless and available to all investors Investors make optimal investment decisions Homogeneous expectations

Resulting Equilibrium Conditions of CAPM Investors will ____________________ All investors will hold the same portfolio of risky assets – the _________ portfolio Market portfolio contains all securities and the proportion of each security is its market value as a percentage of total market value

Figure 7-1 The Efficient Frontier and the Capital Market Line

Total Risk & Systematic Risk Total Risk = Systematic + Firm-specific Risk Risk Risk Risk Because firm-specific risk can be eliminated by diversifying, the only type of risk that is relevant to diversified investors is systematic risk (measured by beta)

Security Market Line According to CAPM, the required return on a security (or a portfolio) is shown by the Security Market Line (SML). The SML relationship can be shown algebraically or graphically. r X = r f +  X (ER M – r f ) Where r X = required return on X ER M – r f = Market risk premium ER M – r f = Market risk premium

r E(r M ) rfrfrfrf SML M ß ß = 1.0 Security Market Line

Sample Calculations for SML E(R m ) - r f =.08 = Market risk premium r f =.03  x = 1.25 r x = (.08) = _________________ = required return on X = required return on X  y =.6 r y = (.08) = ________________ = required return on Y = required return on Y

Disequilibrium Example Suppose a security X with a  of 1.25 has a predicted return of 15% According to SML, its required return is 13% X is _____________________________ in the market: it offers too high of a rate of return for its level of risk

E(r) 15% SML ß 1.0 R m =11% r f =3% 1.25 Disequilibrium Example

For Stock X, with a predicted return of 15% and a required return of 13%:  X = predicted return – required return = 15% - 13% = 2% = 15% - 13% = 2% Stocks with _______________________ alphas are undervalued. Their predicted returns plot above the SML.

Multifactor Models Limitations of CAPM: –Market Portfolio is not directly observable –Research shows that other factors affect returns

Fama French Research Returns are related to factors other than market returns: –Size –Book value relative to market value Three factor model developed by Fama and French better describes returns