THE CAPITAL ASSET PRICING MODEL
This chapter presents the capital asset pricing model, which is an equilibrium model for the pricing of
assets based upon risk. This model rules out the possibility of arbitrage profits, that is, the exploitation
of mispriced securities. The chapter begins with a simplified two-security example that develops the
concept of demand for shares and how prices of securities would change with changes in demand. The
presentation includes the assumptions that underlie the CAPM, major implications of model and
development of the Security Market Line. Extensions covered in the chapter include the zero beta model
and incorporation of liquidity costs.
After studying this chapter, the student should have a thorough understanding of the development and the
theory of the capital asset pricing model (CAPM), to be able to construct and use the security market
line. The student should also have a thorough understanding of the zero beta formulization and the
impact that differential liquidity costs may have on expected return.
PRESENTATION OF MATERIAL
1. Development of the Capital Asset Pricing Model
The introduction of the CAPM starts with an overview of the importance of the model and the
assumptions that underlie it.
PPT 9-2 Capital Asset Pricing Model (CAPM)
PPT 9-3 Assumptions
PPT 9-4 Assumptions (cont.)
The implications or conditions that will result from the CAPM are contained in PPT 9-5 and PPT 9-6.
Discussion of the equilibrium conditions that will result from the model is very important before the
analytical development of the CAPM.
PPT 9-5 Resulting Equilibrium Conditions
PPT 9-6 Resulting Equilibrium Conditions (cont.)
Once the major implications and conditions have been discussed, the Capital Market Line can be
examined. The Capital Market Line (CML) in shown in PPT 9-7 and the market risk premium and slope
are displayed in PPT 9-8. In discussing the CML, it is helpful to tie in the concept of dominance covered
in previous chapters. The conclusion that investors, regardless of their risk preferences, will combine the
market portfolio with the risk free rate is very important to discuss.
PPT 9-7 Figure 9.1 The Efficient Frontier and the Capital Market Line
PPT 9-8 Slope and Market Risk Premium
Since the equilibrium conditions result in all investors holding the same portfolio of risky investments,
pricing on individual securities is related to the risk that individual securities have when they are
included in the market portfolio. The relevant measure of risk is the covariance of returns on the
individual securities with the market portfolio.
PPT 9-9 Return and Risk for Individual Securities
Given the relevant measure of risk is the risk that is related to the market portfolio, the Security Market
Line describes that relationship. The slope of the SML is the market risk premium. The beta for the
individual security is the [Cov (ri,rm)]/Var rm. When first examining these concepts, students often
confuse the slope of the SML with the slope of the Security Characteristic Line. It is useful to spend
class discussion time clarifying the differences in these relationships.
PPT 9-10 Figure 9.2 The Security Market Line
PPT 9-11 Figure 9.3 The SML and a Positive-Alpha Stock
2. The CAPM and the Index Model
The CAPM would predict alpha values of zero for all securities. We find that alphas are not exactly zero
as suggested by the model but the distribution of alpha’s show that they are distributed around a mean of
PPT 9-12 Figure 9.4 Frequency Distribution of Alphas
3. The CAPM and Reality
Students and practitioners often criticize the CAPM because of the simplistic assumptions. While the
model is not exactly met, it has been widely accepted and fairly robust. Some of the key criticisms of the
model are presented in PPT 9-13.
PPT 9-13 The CAPM and Reality
4. Extensions to the Capital Asset Pricing Model
A few of the more important extensions of the CAPM are presented in PPT 9-14. Black’s Zero Beta
Model, the incorporation of labor income and nontraded assets and Merton’s Multiperiod Model are
among the more important extensions.
PPT 9-14 Extensions of the CAPM
The CAPM is built on the assumption of frictionless markets. Assets display different levels of liquidity
and consideration of illiquidity premiums has shown some promising results.
PPT 9-15 CAPM & Liquidity
PPT 9-16 Figure 9.5 The Relationship Between Illiquidity and Average Returns