Chapter 18 CAPITAL ASSET PRICING THEORY• What is the capital market line (CML)?

• How is the Capital Asset Pricing Model (CAPM) developed?

• What is the difference between the standard deviation risk and beta risk measures?

• How can an investor apply the CAPM to security analysis?

• How do you estimate beta?

• What are the good news and the bad news about beta?

Assumptions of the Capital Asset Pricing Model• Investors have homogeneous

expectations

• Frictionless capital markets

• Investors are rational and seek to maximize their expected utility functions

• Investment is for one-period only

• All investors can borrow or lend at the riskfree rate

Efficient frontier and the optimal risky portfolio

• Developing the capital market line (CML)

– Introducing the riskfree asset.

– The capital market line (CML) or the borrowing-lending line.

– The Portfolio Separation Theorem

– The market portfolio, M

Figure 18.1 – Efficient Frontier

Figure 18.2 – Efficient Frontier and Utility Curves for Investors A and B

Figure 18.3 – Combinations of the Risk-Free Asset RF and Risky Portfolios P1 and P2

Figure 18.4 – Combinations of the Risk-Free Asset RF and the Risky Portfolio M

Figure 18.5 – CML and Individual Utility Curves

Figure 18.6 – CML: The Borrowing-Lending Line

Capital Asset Pricing Model

• Developing a relative risk measure

• Understanding beta

– Systematic risk or market risk

– Diversifiable risk or firm-specific risk

Figure 18.7 – CML and Individual Securities

CAPM derivation

• Security risk and return

– Reward for investing in a security

– Security risk

– Security’s reward-to-risk ratio

– Risk/return relationship

– The security market line (SML)

• Differences between the CML and SML

Figure 18.8 – Security Market Line (SML)

CAPM and security analysis

• Estimating the required return.

• Estimating the predicted return.

• Security analysis decision rule.

• Comparison with fundamental analysis.

Estimating Beta

• Security characteristic line

• Information service beta estimates

• Calculating beta: Separating systematic risk from diversifiable risk.

• Differences between the SML and the security characteristic line

Good news and bad news about Beta

• How reliable are beta estimates?

• Does beta really measure risk?

• The verdict on beta.

• Implications for investors

Figure 18.9 – Security Market Line Analysis

Figure 18.10 – Regression Analysis to Estimate Beta