Chapter 6
The Capital
The Capital
Asset Pricing
Model

Demand for Stocks and
Equilibrium Prices
Imagine a world where all investors face
the same opportunity set
Each investor computes his/her optimal
(tangency) portfolio
The demand of this investor for a
particular firm’s shares comes from this
tangency portfolio

Demand for Stocks and
Equilibrium Prices (cont’d)
As the price of the shares falls, the
demand for the shares increases
The supply of shares is vertical
, fixed and
independent of the share price
The CAPM shows the conditions that
prevail when supply and demand are
equal for all
firms in investor’s
opportunity set

Equilibrium model that underlies all
modern financial theory
Derived using principles of diversification
with simplified assumptions
Markowitz, Sharpe, Lintner and Mossin
are researchers credited with its
development
Capital Asset Pricing
Model (CAPM)

THE CAPM ASSUMPTIONS
NORMATIVE ASSUMPTIONS
expected returns and standard deviation
cover a one-period investor horizon
nonsatiation
risk averse investors
assets are infinitely divisible
risk free asset exists
no taxes nor transaction costs

THE CAPM ASSUMPTIONS
ADDITIONAL ASSUMPTIONS
one period investor horizon for all
risk free rate is the same for all
information is free and instantaneously
available
homogeneous expectations

All investors will hold the same portfolio of
risky assets – market portfolio
Market portfolio
contains all securities
and the proportion of each security is its
market value as a percentage of total
market value
The market portfolio is on the efficient
frontier and, moreover, it is the tangency
portfolio
Resulting Equilibrium
Conditions

Risk premium on the market depends on
the average risk aversion of all market
participants
Risk premium on an individual security is
a function of its covariance with the
market
Resulting Equilibrium
Conditions (cont’d)

Capital Market Line
E(r)
E(r
M
)
r
f
M
CML
m

M
=
The market portfolio
r
f
=
Risk free rate
E(r
M
) - r
f
=
Market risk premium
=
Slope of the CML
Slope and Market Risk
Premium
M
f
M
r
)
r
(
E

The risk premium on individual securities
is a function of the individual security’s
contribution to the risk of the market
portfolio
Individual security’s risk premium is a
function of the covariance of returns with
the assets that make up the market
portfolio
Expected Return and Risk
on Individual Securities

The Risk of an Individual
Asset1
Step 1: Individuals diversify and hold
portfolios
Step 2: The risk of a security is the risk
it adds to the portfolio
Step 3: Everybody holds the market
portfolio
Step 4: The risk of a security is the risk
that it adds to the market portfolio.

The Risk of an Individual
Asset2
Step 5: The covariance between an asset
"i" and the market portfolio (Cov
im
) is a
measure of this added risk. The higher
the covariance the higher the risk.

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