FINANCE 10. Capital Asset Pricing Model.ppt

FINANCE10. Capital Asset Pricing Model
Professor André Farber
Solvay Business School
Université Libre de Bruxelles
Fall 2007
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MBA 2007 CAPM
Capital asset pricing model (CAPM)
Sharpe (1964) Lintner (1965)
Assumptions
Perfect capital markets
Homogeneous expectations
Main conclusions: Everyone picks the same optimal portfolio
Main implications:
1. M is the market portfolio : a market value weighted portfolio of all stocks
2. The risk of a security is the beta of the security:
Beta measures the sensitivity of the return of an individual security to the return of the market portfolio
The average beta across all securities, weighted by the proportion of each security's market value to that of the market is 1
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MBA 2007 CAPM
Risk premium and beta
3. The expected return on a security is positively related to its beta
Capital-Asset Pricing Model (CAPM) :
The expected return on a security equals:
the risk-free rate
plus
the excess market return (the market risk premium)
times
Beta of the security
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MBA 2007 CAPM
CAPM - Illustration
Expected Return
Beta
1
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MBA 2007 CAPM
CAPM - Example
Assume: Risk-free rate = 6% Market risk premium = %
Beta Expected Return (%)
American Express
BankAmerica
Chrysler
Digital Equipement
Walt Disney
Du Pont
AT&T
General Mills
Gillette
Southern California Edison
Gold Bullion -
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MBA 2007 CAPM
Measuring the risk of an individual asset
The measure of risk of an individual asset in a portfolio has to incorporate the impact of diversification.
The standard deviation is not an correct measure for the risk of an individual security in a portfolio.
The risk of an individual is its systematic risk or market risk, the risk that can not be eliminated through diversification.
Remember: the optimal portfolio is the market portfolio.
The risk of an individual asset is measured by beta.
The definition of beta