THE CAPITAL ASSET PRICING MODEL

As shown in Section 11.6, once we can identify the efficient portfolio, we can compute the expected return
of any security based on its beta with the efficient portfolio according to Eq. 11.21. But to implement this
approach, we face an important practical problem: To identify the efficient portfolio we must know the
expected returns, volatilities, and correlations between investments. These quantities are difficult to forecast.
Under these circumstances, how do we put the theory into practice?

To answer this question, we revisit the Capital Asset Pricing Model (CAPM), which we introduced in
Chapter 10. This model allows us to identify the efficient portfolio of risky assets without having any
knowledge of the expected return of each security. Instead, the CAPM uses the optimal choices investors
make to identify the efficient portfolio as the market portfolio, the portfolio of all stocks and securities in
the market. To obtain this remarkable result, we make three assumptions regarding the behavior of
investors.11

The CAPM Assumptions

Three main assumptions underlie the CAPM.

1. Investors can buy and sell all securities at competitive market prices (without incurring taxes or
transactions costs) and can borrow and lend at the risk-free interest rate.
The second assumption is that all investors behave as we have described thus far in this chapter, and choose
a portfolio of traded securities that offers the highest possible expected return given the level of volatility
they are willing to accept:

2. Investors hold only efficient portfolios of traded securities—portfolios that yield the maximum expected
return for a given level of volatility.
Of course, there are many investors in the world, and each may have his or her own estimates of the
volatilities, correlations, and expected returns of the available securities. But investors don’t come up with
these estimates arbitrarily; they base them on historical patterns and other information (including market
prices) that is widely available to the public. If all investors use publicly available information sources, then
their estimates are likely to be similar. Consequently, it is not unreasonable to consider a special case in
which all investors have the same estimates concerning future investments and returns, called homogeneous
expectations. Although investors’ expectations are not completely identical in reality, assuming
homogeneous expectations should be a reasonable approximation in many markets, and represents the third
simplifying assumption of the CAPM:
3. Investors have homogeneous expectations regarding the volatilities, correlations, and expected
returns of securities.

Supply, Demand, and the Efficiency of the Market Portfolio

If investors have homogeneous expectations, then each investor will identify the same portfolio as having
the highest Sharpe ratio in the economy. Thus, all investors will demand the same efficient portfolio of risky
securities—the tangent portfolio in Figure 11.10— adjusting only their investment in risk-free securities to
suit their particular appetite for risk.
But if every investor is holding the tangent portfolio, then the combined portfolio of risky securities of all
investors must also equal the tangent portfolio. Furthermore, because every security is owned by someone,
the sum of all investors’ portfolios must equal the portfolio of all risky securities available in the market,
which we defined in Chapter 10 as the market portfolio. Therefore, the efficient, tangent portfolio of risky
securities (the portfolio that all investors hold) must equal the market portfolio.
market portfolio; hence the two must coincide. If a security were not part of the efficient portfolio, then no
investor would want to own it, and demand for this security would not equal its supply. This security’s price
would fall, causing its expected return to rise until it became an attractive investment. In this way, prices in
the market will adjust so that the efficient portfolio and the market portfolio coincide, and demand equals
supply.
The insight that the market portfolio is efficient is really just the statement that demand must equal supply.
All investors demand the efficient portfolio, and the supply of securities is the

Example 11.15
Portfolio Weights and the Market Portfolio
Problem
Suppose that after much research, you have identified the efficient portfolio. As part of your holdings, you
have decided to invest $10,000 in Microsoft, and $5000 in Pfizer stock. Suppose your friend, who is a
wealthier but more conservative investor, has $2000 invested in Pfizer. If your friend’s portfolio is also
efficient, how much has she invested in Microsoft? If all investors are holding efficient portfolios, what can
you conclude about Microsoft’s market capitalization, compared to Pfizer’s?
Solution
Because all efficient portfolios are combination of the risk-free investment and the tangent portfolio, they
share the same proportions of risky stocks. Thus, since you have invested twice as much in Microsoft as in
Pfizer, the same must be true for your friend; therefore, she has invested $4000 in Microsoft stock. If all
investors hold efficient portfolios, the same must be true of each of their portfolios. Because, collectively,
all investors own all shares of Microsoft and Pfizer, Microsoft’s market capitalization must therefore be
twice that of Pfizer’s.

Optimal Investing: The Capital Market Line

When the CAPM assumptions hold, the market portfolio is efficient, so the tangent portfolio in Figure 11.10
is actually the market portfolio. We illustrate this result in Figure 11.11. Recall that the tangent line graphs
the highest possible expected return we can achieve for any level of volatility. When the tangent line goes
through the market portfolio, it is called the capital market line (CML). According to the CAPM, all
investors should choose a portfolio on the capital market line, by holding some combination of the risk-free
security and the market portfolio.

When investors have homogeneous expectations, the market portfolio and the efficient portfolio coincide.
Therefore, the capital market line (CML), which is the line from the risk-free investment through the market
portfolio, represents the highest-expected return available for any level of volatility. (Data from Figure
11.8.)

11.8 Determining the Risk Premium

Under the CAPM assumptions, we can identify the efficient portfolio: It is equal to the market portfolio.
Thus, if we don’t know the expected return of a security or the cost of capital of an investment, we can use
the CAPM to find it by using the market portfolio as a benchmark.
Market Risk and Beta
In Eq. 11.21, we showed that the expected return of an investment is given by its beta with the efficient
portfolio. But if the market portfolio is efficient, we can rewrite Eq. 11.21 as
(11.22)

where β isthe beta of the security with respect to the market portfolio, defined as (using Eq. 11.19 and Eq.
11.6)

11.6

The beta of a security measures its volatility due to market risk relative to the market as a whole, and thus
captures the security’s sensitivity to market risk.
Equation 11.22 is the same result that we derived intuitively at the conclusion of Chapter 10. It states that
to determine the appropriate risk premium for any investment, we must rescale the market risk premium
(the amount by which the market’s expected return exceeds the risk-free rate) by the amount of market risk
present in the security’s returns, measured by its beta with the market.
We can interpret the CAPM equation as follows. Following the Law of One Price, in a competitive market,
investments with similar risk should have the same expected return. Because investors can eliminate firm-
specific risk by diversifying their portfolios, the right measure of risk is the investment’s beta with the
market portfolio, As the next example demonstrates, the CAPM Eq. 11.22 states that the investment’s
expected return should therefore match the expected return of the capital market line portfolio with the same
level of market risk.

Example 11.16
Computing the Expected Return for a Stock
Problem
Suppose the risk-free return is 4% and the market portfolio has an expected return of 10% and a volatility
of 16%. 3M stock has a 22% volatility and a correlation with the market of 0.50. What is 3M’s beta with
the market? What capital market line portfolio has equivalent market risk, and therefore what is 3M’s
expected return according to the CAPM?
Solution
That is, for each 1% move of the market portfolio, 3M stock tends to move 0.69%. We could obtain the
same sensitivity to market risk by investing 69% in the market portfolio, and 31% in the risk-free security.
Because it has the same market risk, 3M’s stock should have the same expected return as this portfolio,
which is (using

Example 11.17
A Negative-Beta Stock
Because the expected return of the market is higher than the risk-free rate, Eq. 11.22 implies that the
expected return of BAS will be below the risk-free rate. For example, if the risk-free rate is 4% and the
expected return on the market is 10%,

This result seems odd: Why would investors be willing to accept a 2.2% expected return on this stock
when they can invest in a safe investment and earn 4%? A savvy investor will not hold BAS alone;
instead, she will hold it in combination with other securities as part of a well-diversified portfolio.
Because BAS will tend to rise when the market and most other securities fall, BAS provides “recession
insurance” for the portfolio. That is, when times are bad and most stocks are down, BAS will do well and
offset some of this negative return. Investors are willing to pay for this insurance by accepting an expected
return below the risk-free rate.

Nobel Prize
William Sharpe on the CAPM

William Sharpe received the Nobel Prize in 1990 for his development of the Capital Asset Pricing Model.
Here are his comments on the CAPM from a 1998 interview with Jonathan Burton:*
Portfolio theory focused on the actions of a single investor with an optimal portfolio. I said, What if
everyone was optimizing? They’ve all got their copies of Markowitz and they’re doing what he says.
Then some people decide they want to hold more IBM, but there aren’t enough shares to satisfy demand.
So they put price pressure on IBM and up it goes, at which point they have to change their estimates of
risk and return, because now they’re paying more for the stock. That process of upward and downward
pressure on prices continues until prices reach an equilibrium and everyone collectively wants to hold
what’s available. At that point, what can you say about the relationship between risk and return? The
answer is that expected return is proportionate to beta relative to the market portfolio.
The CAPM was and is a theory of equilibrium. Why should anyone expect to earn more by investing in
one security as opposed to another? You need to be compensated for doing badly when times are bad.
The security that is going to
do badly just when you need money when times are bad is a security you have to hate, and there had
better be some redeeming virtue or else who will hold it? That redeeming virtue has to be that in normal
times you expect to do better. The key insight of the Capital Asset Pricing Model is that higher expected
returns go with the greater risk of doing badly in bad times. Beta is a measure of that. Securities or asset
classes with high betas tend to do worse in bad times than those with low betas.
The CAPM was a very simple, very strong set of assumptions that got a nice, clean, pretty result. And
then almost immediately, we all said: Let’s bring more complexity into it to try to get closer to the real
world. People went on—myself and others—to what I call “extended” Capital Asset Pricing Models, in
which expected return is a function of beta, taxes, liquidity, dividend yield, and other things people might
care about.
Did the CAPM evolve? Of course. But the fundamental idea remains that there’s no reason to expect
reward just for bearing risk. Otherwise, you’d make a lot of money in Las Vegas. If there’s reward for
risk, it’s got to be special. There’s got to
be some economics behind it or else the world is a very crazy place. I don’t think differently about those
basic ideas at all.
 * Jonathan Burton, “Revisiting the Capital Asset Pricing Model,” Dow Jones Asset Manager (May/June
1998): 20–28.

THE SECURITY MARKET LINE

Equation 11.22 implies that there is a linear relationship between a stock’s beta and its expected return.
Panel (b) of Figure 11.12 graphs this line through the risk-free investment (with a beta of 0) and the market
(with a beta of 1); it is called the security market line (SML). Under the CAPM assumptions, the security
market line (SML) is the line along which all individual securities should lie when plotted according to their
expected return and beta, as shown in panel (b).
Figure 11.12
The Capital Market Line and the Security Market Line

a) The CML depicts portfolios combining the risk-free investment and the efficient portfolio, and shows
the highest expected return that we can attain for each level of volatility. According to the CAPM, the
market portfolio is on the CML and all other stocks and portfolios contain diversifiable risk and lie to
the right of the CML, as illustrated for McDonald’s (MCD).
 B. The SML shows the expected return for each security as a function of its beta with the market.
According to the CAPM, the market portfolio is efficient, so all stocks and portfolios should lie on the SML.

Contrast this result with the capital market line shown in panel (a) of Figure 11.12, where there is no clear
relationship between an individual stock’s volatility and its expected return. As we illustrate for McDonald’s
(MCD), a stock’s expected return is due only to the fraction of its volatility that is common with the

market— the distance of each stock to the right of the

capital market line is due to its diversifiable risk. The relationship between risk and return for individual
securities becomes evident only when we measure market risk rather than total risk.

Beta of a Portfolio
Because the security market line applies to all tradable investment opportunities, we can apply it to portfolios
as well. Consequently, the expected return of a portfolio is given by Eq. 11.22 and therefore depends on the
portfolio’s beta. Using Eq. 11.23, we calculate the beta of a portfolio as follows:

(11.24)
In other words, the beta of a portfolio is the weighted average beta of the securities in the portfolio.

Example 11.18
The Expected Return of a Portfolio
Problem
Suppose Kraft Foods’ stock has a beta of 0.50, whereas Boeing’s beta is 1.25. If the risk-free rate is 4%,
and the expected return of the market portfolio is 10%, what is the expected return of an equally weighted
portfolio of Kraft Foods and Boeing stocks, according to the CAPM?
Solution
We can compute the expected return of the portfolio in two ways. First, we can use the SML to compute
the expected return of Kraft Foods (KFT ) and Boeing (BA) separately:

Summary of the Capital Asset Pricing Model

In these last two sections, we have explored the consequences of the CAPM assumptions that markets are
competitive, investors choose efficient portfolios, and investors have homogeneous expectations. The
CAPM leads to two major conclusions:
• The market portfolio is the efficient portfolio. Therefore, the highest expected return for any given level
of volatility is obtained by a portfolio on the capital market line, which combines the market portfolio
with risk-free saving or borrowing.
• The risk premium for any investment is proportional to its beta with the market. Therefore, the
relationship between risk and the required return is given by the security market line described by Eq.
11.22 and Eq. 11.23.
The CAPM model is based on strong assumptions. Because some of these assumptions do not fully describe
investors’ behavior, some of the model’s conclusions are not completely accurate—it is certainly not the
case that every investor holds the market portfolio, for
instance. We will examine individual investor behavior in more detail in Chapter 13, where we also
consider proposed extensions to the CAPM. Nevertheless, financial economists find the qualitative intuition
underlying the CAPM compelling, so it is still the most common and important model of risk and return.
While not perfect, it is widely regarded as a very useful approximation and is used by firms and practitioners
as a practical means to estimate a security’s expected return and an investment’s cost of capital. In Chapter
12, we will explain in more detail how to implement the model, looking more closely at the construction of
the market portfolio and developing a means to estimate the betas of firms’ securities as well as their
underlying investments.
Concept Check
1. What is the security market line (SML)?
2. According to the CAPM, how can we determine a stock’s expected return?

Resumen final:

The Capital Asset Pricing Model

• Three main assumptions underlie the Capital Asset Pricing Model (CAPM):
▪ Investors trade securities at competitive market prices (without incurring taxes
or transaction costs) and can borrow and lend at the risk-free rate.
▪ Investors choose efficient portfolios.
▪ Investors have homogeneous expectations regarding the volatilities,
correlations, and expected returns of securities.
• Because the supply of securities must equal the demand for securities, the CAPM implies that
the market portfolio of all risky securities is the efficient portfolio.
• Under the CAPM assumptions, the capital market line (CML), which is the set of portfolios
obtained by combining the risk-free security and the market portfolio, is the set of portfolios
with the highest possible expected return for any level of volatility.
• The CAPM equation states that the risk premium of any security is equal to the market risk
premium multiplied by the beta of the security. This relationship is called the security market
line (SML), and it determines the required return for an investment