• A market is in equilibrium when all investors hold their optimal portfolio and hence there is

no reason for further transactions

• The basic question of CAPM: ‘What are the equilibrium rates of return if all investors apply
the mean-variance criterion to an identical mean-variance efficient set?’
• The CAPM follows from the linear efficient set (the extension to the Markowitz model) but
requires additional assumptions
• Its major conclusion is that expected returns on an equity stock are related to its systematic
risk and not to its total risk or standard deviation
• Components of Risk
• Diversifiable (Unsystematic) Risk: results from factors that are firm-specific.
• Examples: whether a new product succeeds or fails, the performance of senior managers, or a
firms’ relationship with its customers and suppliers
• Undiversifiable (Systematic) Risk: the inescapable portion of an investment’s risk that
remains even if a portfolio is well diversified.
• Associated with broad forces such as economic growth, inflation, interest rates, and political
events
• Also called market risk
• Total risk = Diversifiable risk + Undiversifiable risk
Assumptions about CAPM
1) All investors are assumed to follow the mean-variance approach
 i.e. the risk-averse investor will reduce portfolio risk by combining assets with
counterbalancing correlations
2) Investors have homogeneous expectations
 i.e. all investors have the same expectations w.r.t. the inputs that are used to derive the
Markowitz efficient portfolios: asset returns, variances and correlations
3) All investors have the same holding period
4) Information is freely and instantly available to all investors
5) There is a risk-free rate at which an investor may lend or borrow and the risk-free rate is the same
for all investors
6) Markets are assumed to be perfectly competitive
 i.e. the number of buyers and sellers is sufficiently large, and all investors are small
enough relative to the market, so that no individual investor can influence an asset’s
price
 Consequently, all investors are price takers, and the market price is determined where
there is equality of supply and demand
7) Taxes & transactions costs are ignored
• The Risk-free Asset
 The rate of return of this asset is known with certainty
(Short-term treasury bills often used as proxy for the risk-free rate)
The Market Portfolio
Includes all available risky capital assets in the world and weights the assets by their relative
market value

The equilibrium proportion of each asset in the market portfolio must be

market value of asset i
w i=
market value of all assets
So, for example, if the total market value of an asset is £500m and the market value of all assets is £X,
then the percentage of the portfolio that should be allocated to that asset is £500m divided by £X
• Market portfolio is a portfolio of all available risky capital assets (e.g., stocks, bonds) in the
world
 Market portfolio contains only systematic risk
 Not practical to find such a portfolio
• Common practice is to use the S&P 500 (FTSE 100, Nikkei 225) portfolio as an
approximation for the market portfolio

• The tangency portfolio must be the market portfolio since the market portfolio is simply the
sum of all individual holdings
– The market portfolio provides all investors, regardless of their preferences, with the
highest utility they can achieve when risk-free borrowing and lending are available
• The linear efficient set is then called the capital market line
Properties of Capital Market Line :
• The CML establishes that the expected return on a portfolio is equal to the risk-free rate plus a
risk premium
 • It provides a simple linear relationship between risk and return for efficient portfolios
• The intercept of CML is the risk-free rate r
– It is often referred to as the reward for waiting
or price of time
The slope of CML is [E(Rm)-r]/σm
– The numerator of the slope coefficient is the expected return of the market beyond the
risk-free return
• It is a measure of the reward for holding the risky market portfolio rather than
the risk-free asset
– The denominator is the risk of the market portfolio
– Thus, the slope measures the reward per unit of market risk
• It is referred to as the reward per unit of risk borne or price of risk

[ E ( Rm ) −r ]
E ( R p ) =r + σp
σm

R = interest rate
Price is time is intercept and slope is risk price. Equation to find CML
The separation Theorem : Given the assumptions behind the CAPM, and the resulting CML, one can
separate the investment process into two stages:
1. Determining the market portfolio
Because all investors hold the same portfolio, there’s no need to know the investors’ individual
preferences at this stage
2. Adjusting the return characteristics by mixing the market portfolio with the risk-free asset
This stage is based on each investor’s individual preferences
SML Properties :
• The SML must go through the point representing the market portfolio itself. Its beta is 1 and
its expected return is , so its coordinates are (1, )
• It must also go through the point representing the risk free asset, which has coordinates (0, r)
• It has a vertical intercept equal to the risk free rate r, and a slope equal to the vertical distance
between these two points divided by the horizontal distance between these two points. Thus
these two points suffice to fix the location of the SML
• The SML represents equilibrium, i.e. the situation where all investors hold their optimal
portfolio and hence there is no further demand for or supply of the assets
• In equilibrium all assets and portfolios must therefore plot on the SML
• e.g. asset A is under the SML i.e. it is overpriced, hence supply will increase, there
will be downward pressure on its price and the expected return will increase until it
reaches A’
• B is underpriced, hence demand for this asset will increase, and market force will
push the price up and the expected return down until it reaches B’
 • The CAPM is based on a specific set of assumptions about investor behavior and the
existence of perfect security markets
– Investors will hold the same efficient portfolio of risky assets
– Investors will differ only in the amounts of risk-free borrowing or lending they
undertake
• The risky portfolio held by all investors is known as the market portfolio
– The market portfolio consists of all securities, each weighted in proportion to its
market value relative to the market value of all assets
• The linear efficient set of the CAPM is known as the CML
– It represents the equilibrium relationship between the expected return and standard
deviation of efficient portfolios
• Under the CAPM the relevant measure of risk for determining an asset’s expected return is its
covariance with the market portfolio
• Beta is a measure of the covariance between the asset and the market portfolio relative to the
market portfolio’s variance
• The linear relationship between beta and expected return is known as the SML
• The total risk of a security can be separated into market risk and non-market risk
• The CAPM forms the basis for deriving many alternative asset pricing models, as well as the
benchmark for gauging the empirical validity of those alternatives

Seminar Questions :
(a) How do you interpret these betas? ANSWER: Beta can be considered (i) a measure of the
sensitivity of the stock return to movements in the return of the market portfolio and (ii) a
measure of the systematic risk of a stock. For instance, from the table we note that HSBC
has the highest sensitivity to the market (i.e. a one unit change in market return produces
a 1.2 unit change in stock return, ceteris paribus) (b) Is it reasonable to assume that the
expected return on Sony is higher than that on Tesco shares? ANSWER: Sony has a beta
of 0.8 compared to 0.6 for Tesco. Therefore Sony is more sensitive to movements in the
market portfolio than Tesco. If we believe that beta is the only relevant measure of risk
then it is appropriate to assume that the expected return on Sony should be higher than
Tesco i.e. more of an incentive is required for risk-averse investors to buy Sony stock as it
is riskier. (c) Indicate why you agree or disagree with the following statement: “Given
that American Express has a beta of 1, one can mimic the performance of the stock
market as a whole by buying only these shares.” ANSWER: Disagree. The return on one
stock is comprised of both systematic and unsystematic components. The unsystematic
return on American Express stock will likely mean that the performance of the stock
could be different from that of the market.
HSBC = 1.2 , Tesco = 0.6 , Sony = 0.8, AMEX = 1.00
How can we tell if securities are under or overvalued by using the security market line? ANSWER: If
the asset is below the SML, its expected return is too low relative to its beta and it is overvalued. If the
asset is above the SML, its expected return is too high relative to its beta and it is undervalued. The
vertical distance of the assets from the SML measures the pricing error, the difference between the
actual expected rate of return and the equilibrium rate. Traders will keep buying securities
undervalued and sell securities overvalued until they reach their equilibrium returns. For example, if
the actual expected return on asset A is 5%, but the one derived from the SML is 8%, we may infer
that asset A is overpriced, vice versa. Also see P305 first paragraph in the textbook. QUESTION 5
What are the general conclusions of studies that have empirically investigated the CAPM? ANSWER:
The empirical tests of the CAMP have failed to fully support the CAPM theory.
Standard Deviation of the Portfolio
The standard deviation of the portfolio (𝜎𝑝σp) is calculated considering only the risky part of the
investment because the risk-free asset has no volatility (standard deviation of 0). The formula is:
𝜎𝑝= wrσr
where
 𝑤𝑟wr is the weight of the investment in the risky asset (40% or 0.40).
 𝜎𝑟σr is the standard deviation of the risky asset (20% or 0.20).


 The expected return of the portfolio (𝐸(𝑅𝑝)E(Rp)) can be calculated using the
weighted average of the expected returns of the risky asset and the risk-free asset.
The formula is:

 𝐸(𝑅𝑝)=𝑤𝑟𝐸(𝑅𝑟)+𝑤𝑓𝐸(𝑅𝑓)E(Rp)=wrE(Rr)+wfE(Rf)