Capital Asset


UNIT 12 CAPITAL ASSET PRICING MODEL Pricing Model

Structure
12.0 Objectives
12.1 Introduction
12.2 Passive and Active Management Investment
12.3 The Capital Market Line (CML)
12.4 Leveraged Portfolios
12.5 Types of Risk
12.5.1 Non-systematic Risk
12.5.2 Systematic Risk
12.6 Capital Asset Pricing Model (CAPM)
12.6.1 Assumptions of the CAPM
12.6.2 The Security Market Line & CAPM
12.6.3 Applications of the CAPM
12.6.4 Limitations of the CAPM
[Link] Theoretical Limitations of the CAPM
12. 6.4.2 Practical Limitations of the CAPM
12.7 Let Us Sum Up
12.8 Answers/Hints to Check Your Progress Exercises

12.0 OBJECTIVES
After studying this Unit, you should be able to:
• Explain the concept of a market line;
• Differentiate between systematic and non-systematic risk;
• Discuss the Capital Asset Pricing Model (CAPM); and
• Highlight the limitations of the CAPM.


Contributed by Dr. Karan Sabherwal, Assistant Professor, Delhi Technical Campus, Greater
NOIDA
221
Asset Pricing
12.1 INTRODUCTION
To find an optimal portfolio among many risky portfolios for the investor using
the capital asset pricing model (CAPM), it is necessary to know the computation
of risk and return of a portfolio and the role of correlation in diversifying
portfolio risk. This has already been covered in Unit 10. In this unit, we will
understand the concept of the capital market line, which is a special case of the
capital allocation line. To understand the CAPM model, it is very important to
know the difference between systematic and non-systematic risk and also answer
why there is compensation for taking a systematic risk but no compensation for
taking a non-systematic risk. Finally, the CAPM, which is a simple model used
for estimating asset returns using systematic risk only, will be discussed in detail.
We will start our discussion with the capital market line and capital allocation
line. The unit will introduce leveraged portfolios and the pricing of risk in terms
of systematic risk and non-systematic risk because we will decompose total risk
into systematic and non-systematic risk. Then, the capital asset pricing model
will be introduced to estimate the required return of the equity or portfolio and
the relation between CAPM and the security market line. Further, we will discuss
the assumptions behind the CAPM, its applications and limitations.

12.2 PASSIVE AND ACTIVE MANAGEMENT

INVESTMENT
A market which fully reflects all the publicly available information in its prices is
termed an informationally efficient market. In such markets, price is an
unbiased estimate of all future discounted cash flows i.e. investors cannot expect
to earn a return that is greater than the required rate of return for that asset. Thus,
investors cannot outperform the market through active asset management
strategies and investment in the calculation of an investor's estimates of cash
flows and rate of return is not significant too.
The best strategy in an informationally efficient market is to make decisions
based on the prices set by the market. It is the most simple and convenient
approach to investing in the market portfolio as we know that market prices are
unbiased. The portfolios based on this assumption are referred to as passive
portfolios. They are also called index funds as they are based on market indices.
Such portfolios develop and track market indexes and replicate their performance
based on market prices and market capitalizations. Examples are the S&P 500
Index, the Nikkei 300, etc. These portfolios are low costs because no technical
analysis is expended which requires special skills, knowledge and expertise in
valuing securities. Passive investors are involved in fundamental analysis for
valuing investment portfolios.
In contrast to passive investors, active investors have more confidence in their
ability to estimate cash flows, growth rates, and discount rates. Thus, they may
222
not rely on market valuations. Based on these estimates, they value assets and Capital Asset
Pricing Model
determine whether an asset is undervalued, fairly valued or overvalued.
Undervalued security carries positive weight in the portfolio as it has a chance of
offering above-normal returns. In an actively managed portfolio, such assets are
overweighted as compared to the market weight in the benchmark index. In case
short selling is permitted for the security, the weight of the security may be zero
or negative i.e., some assets will be under-weighed compared with the market
weight in the benchmark index. Short selling is defined as a transaction in
which:
a) Securities are borrowed from the lender.
b) Borrowed securities are sold to a seller in such a way that they can be
repurchased at a lower price at a future date, and
c) Then these securities are returned to the lender.
Short selling is an active investment strategy and the portfolios obtained are
referred to as active portfolios. Open-ended mutual funds and hedge funds use
active investment management techniques to value investments and add value to
the investment of the investor.

12.3 THE CAPITAL MARKET LINE (CML)

In unit 10, we discussed how a capital allocation line (CAL) was constructed
with different combinations of a risk-free asset and a risky portfolio with
different weights for the two assets. In this section, we discuss a special case of
CAL in which a risk-free asset is combined with the market portfolio to create an
optimal risky portfolio for the investor. This specific type of CAL is known as
the capital market line. We know that the risk-free asset (Rf) is a debt security
which is free from all kinds of risks such as default risk, inflation risk, liquidity
risk, interest rate risk, etc. For example, Treasury bills issued by the government
are usually used as a proxy to measure the risk-free return, Rf.
Now we will turn our attention to the second important part of CML the market
portfolio. For example, the S&P 500 may be considered a proxy of the market
portfolio to measure the expected return on the risky portfolio which is expressed
as the expected market return, E(Rm). The capital market line is drawn by
measuring the standard deviation (σp), or total risk, on the x-axis and the
expected market portfolio return, E(Rp), is on the y-axis.
Markowitz's efficient frontier has a very important role in choosing a market
portfolio for an investor. The point of tangency of the line from the risk-free asset
and the Markowitz efficient frontier determines the market portfolio. Graphically,
all points on the interior of the Markowitz efficient frontier are inefficient
whereas the points above the CML are not achievable for an investor given the
resources. Portfolios under CML are considered inefficient because they provide
the same level of return with a higher level of risk or a lower level of return with 223
Asset Pricing the same amount of risk. Based on the market prices and market capitalizations,
the point at which the CML is tangent to the Markowitz efficient frontier is the
optimal combination of risky assets. This optimal combination of risky assets is
the optimal risky portfolio i.e. the market portfolio.

Expected Portfolio return E(RP) Points above the

CML are not
CML
achievable
Efficient
E(Rm) frontier
M
Individual
Securities

Rf

Standard Deviation of Portfolio 𝜎𝑃

Figure 1: Capital Market Line

The intercept of the CML on the y-axis is the risk-free return (Rf) and the slope is
positive based on the risk and returns relationship which is considered positive.
Higher risk gives higher returns. The expected market return through which CML
passes is represented by E(Rm). Under the capital market theory, we know that an
investor will not be able to achieve any point above the CML as it is not
achievable and any point below the CML because the points on the CML are
dominated by the points below the CML. They are considered inferior to any
point on the CML.
The risk and return of the portfolio on the CML can be estimated by using the
return and risk formulas for a two-asset portfolio:
𝑅𝑝 = 𝑤𝐴 𝑟𝐴 + 𝑤𝐵 𝑟𝐵

Where 𝑟𝐴 𝑎𝑛𝑑 𝑟𝐵 are the return of Asset A and Asset B respectively and have the
weight of 𝑤𝐴 𝑎𝑛𝑑 𝑤𝐵 of Asset A and Asset B respectively in the portfolio. The
standard deviation of the two asset portfolios is written as:

𝜎𝑝 = √𝑤𝐴2 𝜎𝐴2 + 𝑤𝐵2 𝜎𝐵2 + 2𝑤𝐴 𝑤𝐵 𝜌𝐴𝐵 𝜎𝐴 𝜎𝐵

Correlation between the two returns (𝜌𝐴𝐵 ) and the standard deviations of the two
assets namely, 𝜎𝐴 𝑎𝑛𝑑 𝜎𝐵 .In case an asset is a risk-free asset and the other asset is
risky, the portfolio of these two assets with a portfolio expected return, Rp, risk-
224 free return, rf, and risky asset return, 𝐸(𝑟𝑖 ), can be constructed as follows:
𝑅𝑝 = 𝑤𝐴 𝑟𝑓 + 𝑤𝐵 𝐸(𝑟𝑖 )Equation (1) Capital Asset
Pricing Model
The sum of the weight of a risk-free asset and the weight of the risky asset is 1.
So,𝑤𝐵 = 1-𝑤𝐴 .
𝜎 2 𝑝 = 𝑤𝐴2 𝜎𝑓2 + 𝑤𝐵2 𝜎𝑖2 + 2𝑤𝐴 𝑤𝐵 𝜌𝑖𝑓 𝜎𝑓 𝜎𝑖 Equation (2)

Because the risk-free asset has no risk, that is, σf = 0, the first and third terms in
the formula for variance are zero.
By taking the square root of both sides,
the standard deviation for a portfolio of a risk-free asset and risky asset is given
by:
𝜎𝑝 =𝑤𝐵 𝜎𝑖 Equation (3)
{𝐸(𝑅𝑖 ) − 𝑅𝑓 }
𝑅𝑝 = 𝑅𝑓 + 𝜎𝑝
𝜎𝑖
The observations from the above formula are:
• The CML has a positive slope because as the market’s risk of the risky
portfolio increases, the market return will also increase. Certainly, the market
return is larger than the risk-free return.
As the amount of the total investment in the market assets increases, both
standard deviation (risk) and expected return will also increase.

12.4 LEVERAGED PORTFOLIOS

With different levels of investment varying between 0 per cent and 100 per cent
in the market asset and the remaining in the risk-free assets such as T-bills. The
line connecting risk-free asset (Rf)and market portfolio (M) showing such
portfolios with their respective levels of investment is constructed in figure 2. At
Rf, an investor is lending all his or her wealth into risk-free securities earning a
risk-free rate on his investment. So, at this point till point M, no risk is involved
by investing all of his or her wealth into risk-free securities. The combinations of
the risk-free asset and the market portfolio, which may be achieved by the points
between Rf and M, are termed “lending” portfolios. At Point M, the investor is
holding the market portfolio by not lending any money at the risk-free rate.
Assuming that the lending rate (Rf) and borrowing rate (Rb) are different and the
borrowing rate is higher than the lending rate i.e. Rf<Rb. Thus, an investor can
invest (lend) at Rf, a rate that is lower than the rate at which he can borrow at Rb.
With different lending and borrowing rates, the slope of CML will be different
and hence the line will no longer be a single straight line. To the left of M, the
line will have a larger slope than to the left of M because the points between Rf
and Muse lending rate and the points to the right of M use borrowing rate,
Symbolically, the slopes of both sides are:

225
Asset Pricing [𝐸(𝑅𝑚) – 𝑅𝑓] [𝐸(𝑅𝑚) – 𝑅𝑏]
<
σ𝑚 σ𝑚

Expected Portfolio return E(RP)

Market
portfolio, M

𝐸(𝑅𝑚 ) − 𝑅𝑏
Lending
Borrowing 𝜎𝑚

𝐸(𝑅𝑚 )−𝑅𝑓
Slope =
𝜎𝑚
Rf

Standard Deviation of Portfolio 𝜎𝑃

Figure 2: Leveraged Portfolios on CML
The equations for the two lines are given below.
To the left of M, when the weight of the risk-free asset is zero or positive:
𝐸(𝑅𝑀 )−𝑅𝑓
𝑤𝐴 ≥ 0: 𝐸(𝑅𝑃 ) = 𝑅𝑓 + ( )𝑃
𝜎𝑀

When negative or zero investment occurs in the risk-free assets i.e., to the right of
M, the weight of the market portfolio is positive or higher:
𝐸(𝑅𝑀 )−𝑅𝑏
𝑤𝐴 < 0: 𝐸(𝑅𝑃 ) = 𝑅𝑏 + ( )𝑃
𝜎𝑀

The difference between the two equations is in the borrowing and lending interest
rates used. A risk-averse investor will invest in a leveraged portfolio which
allows increasing the quantum of risk by borrowing or investing more than 100
per cent in the passive portfolio. Thus, all the passive portfolios will lie on the
kinked CML where leveraged portfolios can be chosen. Although, the investment
in the risk-free asset may be
• positive (lending),
• zero (no lending or borrowing),
• or negative (borrowing)
In all the above situations, passive portfolios can be chosen from the kinked
CML.

226
Check Your Progress 1 Capital Asset
Pricing Model
Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) Explain Capital Market Line.
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2) "The points on the CML are the same irrespective of the amount invested by
the investor.” Comment.
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3) What do you understand by leveraged portfolio?
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12.5 TYPES OF RISK

Risk is a very important component in constructing a portfolio. While we have
seen that it is very important to include correlation and standard deviation to
measure the overall risk of a portfolio. However, the risk of the assets that are
less than perfect correlation can be diversified and reduces the risk of a portfolio
of those assets. As a result, the risk of an individual asset held may be greater
than the risk of that asset in a portfolio. Broadly, we have discussed risk in a
portfolio till now. Now we will discuss the types of risk which varies from one
situation to another and which kind of risk is diversified or not. The total risk of
the portfolio can be decomposed into systematic and non-systematic risks.

12.5.1 Non-systematic Risk

Non-systematic risk is one of the components of total risk which is specific to a
particular industry and affects those assets related to that industry or class only.
Since this type of risk is local or limited to a particular asset or industry, they
need not affect assets outside of that asset class. So, they are also called
company-specific, industry-specific, diversifiable, or idiosyncratic risks. For
Example, an airline crash will affect the securities or assets in the airline industry
only. The failure of a drug trial will have an impact on the securities of the
pharmaceutical industry. Therefore, the events in a particular industry will
directly affect their respective class of companies and possibly industries. These
activities will not affect securities that are unrelated to these industries. 227
Asset Pricing To avoid non-systematic risk, Investors can purchase securities from different
industries in such a way that the events in one industry do not affect the events in
the other. The investors through diversification can form a portfolio of assets that
are not highly correlated with one another and reduce portfolio risk. It is
important to note that the investor is not compensated by higher returns by
increasing non-systematic risk because such risk can be diversified in the asset
portfolio.

12.5.2 Systematic Risk

The other component of total risk which cannot be diversified or avoided is
known as systematic risk or non-diversifiable or market risk. These risks affect
the entire market or economy and the whole market suffers. For example,
COVID-19 has affected the entire world and nearly all the assets and industries
have been affected by the spread of the virus. Another example is when the
economy of a country slows down, the financial market or securities in all
industries are affected by the slowdown. These risks cannot be diversified
irrespective of the intensity of the impact. They have to be borne by the investor
and higher systematic risk is compensated by higher returns. These risks are
inherent in the overall market and hence cannot be diversified.
Changes in the interest rates, rate of inflation, movement in the economic cycles,
political uncertainty, and widespread natural disasters affect the entire market,
and there is no way to avoid their effects. However, their effects on the
systematic risk can be magnified by using leverage or diminished by including
poorly correlated securities in the portfolio, that were not included in the
portfolio before. The sum of systematic risk (measured by variance) and non-
systematic risk(measured by variance) equals the total risk(measured by
variance) of the portfolio is given as:
Total risk = Systematic risk + Non-systematic risk
Let us consider a security with both systematic and non-systematic risk. Assume
that each kind of risk is priced in terms of return earned from the security for
taking both systematic risk and non-systematic risk. We know that non-
systematic risk can be diversified away and a large amount of investment must be
made in buying assets that offer a large amount of non-systematic risk. After
owing those assets with non-systematic risk, the non-systematic risk can be
reduced or eliminated through diversification. Thus, non-systematic risk has been
eliminated from your portfolio. The diversified portfolio now has systematic risk
only for which the returns will compensate the investor. Therefore, according to
theory, in an efficient market, no additional reward is earned for taking on non-
systematic or diversifiable risk.
We know that the investors who have non-systematic risk in their portfolio must
diversify it away by investing in different industries, countries, and different asset
228 classes. Such diversification helps in offsetting low returns in one asset class by
reaping higher returns in another asset class, thereby reducing the overall risk of Capital Asset
Pricing Model
the portfolio. Since future returns are uncertain, it is not possible to ensure that
the investor will get positive returns only. On the other hand, the systematic risk
must be compensated to the investors because that risk cannot be diversified
away. Thus, an investor must refuse to accept an investment which does not
commensurate with the amount of systematic risk they are taking by giving
enough returns. In other words, the systematic or non-diversifiable risk is priced
by the returns and investors are compensated for holding portfolios based only on
the portfolio's systematic risk. There are no returns for accepting non- systematic
or diversifiable risk. Therefore, a risk-averse investor must hold only well-
diversified portfolios.
Before we move our attention to the capital asset pricing model (CAPM) which
is one of the return-generating models, let us focus on the single-index model.
Single-index model is a model which involves a single factor. Beta measures the
sensitivity of an asset’s return to the overall market as a whole. It is calculated as
the covariance of the return on an asset i and the return on the market divided by
the variance of the market return;
𝐶𝑜𝑣(𝑅𝑖 , 𝑅𝑚 )
𝛽𝑖 = 2
𝜎𝑚
Asset Beta is the product of the correlation between the asset and the market,
standard deviation and the standard deviation of the asset divided by the variance
of return from the market.
𝜌𝑖,𝑚 𝜎𝑖 𝜎𝑚 𝜌𝑖,𝑚 𝜎𝑖
𝛽𝑖 = 2 =
𝜎𝑚 𝜎𝑚

In other words, Beta is also defined as the product of the correlation between an
asset and the market and the standard deviation of the asset divided by the
standard deviations of return from the market.
𝜌𝑖,𝑚 𝜎𝑖
𝛽𝑖 = 𝜎𝑚

The above expressions show that the beta captures an asset’s systematic risk
which cannot be eliminated by diversification. The historical returns of the asset
and market are used to calculate the variances and correlations required for the
calculation of beta. The sign of beta shows the direction in which the asset
returns and market returns are moving. When the return of an asset follows the
trend of the general market, it is termed a positive beta. Whereas an opposite
trend of the asset to that of the market is termed as negative beta. In other words,
if the movement of the return of an asset and the market happens in the same
direction the market indicates a positive beta. On the other hand, a negative beta
indicates that the movement of the return of an asset and the market happens in
the opposite direction of the market. In the case of a risk-free asset, there is no
systematic risk. Hence, the value of beta is zero. The covariance between the
risk-free asset and the other asset is also zero which means that the asset's return
does not correlate with the trends in the market. 229
Asset Pricing Check Your Progress 2
Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) Explain the concept of expected returns and the Beta of a portfolio.
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2) Differentiate between systematic and non-systematic risk.
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3) Suppose the risk-free rate is 8 per cent, the expected return on the market
portfolio is 15 per cent, and its standard deviation is 23 per cent. A company,
TeaRoom, has a standard deviation of 75 per cent and a correlation of -1 with
the market. Calculate TeaRoom’s beta and expected return.
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12.6 CAPITAL ASSET PRICING MODEL (CAPM)

In this section, we will introduce the calculation of the estimated returns of the
asset with the help of the risk-free rate of the asset, market rate of return and the
given values of the asset betas. The CAPM is usually written with the risk-free
rate as:
𝐸(𝑅𝑖 ) = 𝑅𝑓 + 𝛽𝑖 [𝐸(𝑅𝑚 ) − 𝑅𝑓 ]

The above expression shows that the main factor in the determination of the
expected return for security is its beta. The second part of the expression is
positive which means that there exists a positive relationship between the beta of
an asset and the expected return of the asset. In other words, the higher the beta
of an asset, the higher will be its expected return. The model provides a linear
relationship between the expected return–beta that determines the expected return
of an asset, given its beta. The beta also explains how well the asset correlates
with the market. If 𝛽𝑖 >1 i.e., assets with a beta greater than 1 will have a higher
expected return than that of the market return, whereas if 𝛽𝑖 < 1 i.e., assets with a
beta of less than 1 expected return of the asset will be less than the market return.
Sometimes, assets with low beta are valuable for a portfolio when they reduce the
overall risk of the portfolio even though the return of the asset is less than the
230 risk-free return. Such asset’s beta may be negative which means that the required
return will be less than the risk-free rate. For example, assets such as insurance Capital Asset
Pricing Model
give a positive return to the investor when the wealth of the insured is reduced
because of a sudden loss. However, the insurance premium is paid irrespective of
the occurrence of the loss of the property to the investor. Thus, insurance has a
negative beta and a negative expected return, but the overall risk of the portfolio
is reduced by including insurance.
The capital asset pricing model is one of the most simple and powerful methods
in portfolio theory. The CAPM was introduced by William Sharpe, John Lintner,
Jack Treynor, and Jan Mossin. The model builds its framework on Harry
Markowitz's work on diversification and modern portfolio theory. Two assets
with the same beta will have the same expected return irrespective of the type of
those assets. Given the relationship between risk and return, all assets are defined
only by their beta risk.
Illustration 1:
Suppose the risk-free rate is 5 per cent, the expected return on the market
portfolio is 25 per cent, and its standard deviation is 50 per cent. A Chinese
company, Alibaba, has a standard deviation of 85 per cent but is uncorrelated
with the market. Calculate Alibaba’s beta and expected return.

𝜌𝑖,𝑚 𝜎𝑖 𝜎𝑚 0∗0.5∗0.85
𝛽𝑖 = 2 = =0
𝜎𝑚 (0.5)2

𝐸(𝑅𝑖 ) = 𝑅𝑓 + 𝛽𝑖 [𝐸(𝑅𝑚 ) − 𝑅𝑓 ]

= 0.05 + 0[0.25 – 0.05] = 0.05 or 5%

Illustration 2:
Suppose the risk-free rate is 6 per cent, the expected return on the market
portfolio is 25 per cent, and its standard deviation is 33 per cent. A Canadian
company, Faces Canada, has a standard deviation of 45 per cent and a correlation
of 0.35 with the market. Calculate Faces Canada’s beta and expected return.
𝜌𝑖,𝑚 𝜎𝑖 𝜎𝑚 0.35∗0.33∗0.45 0.1575
𝛽𝑖 = 2 = = = 0.4773
𝜎𝑚 (0.33)2 0.33

𝐸(𝑅𝑖 ) = 𝑅𝑓 + 𝛽𝑖 [𝐸(𝑅𝑚 ) − 𝑅𝑓 ]

= 0.06 + 0.4773 [ 0.25-0.06] = 0.06 + 0.0907 = 0.1507 or 15.07 %

231
Asset Pricing 12.6.1 Assumptions of the CAPM
Every model is developed in the realm of its assumptions and ignores the
complexities of the real world. The simplifying assumptions help to understand
the complexities of the model simply. These assumptions also help to gain
important insights into the process of pricing the assets without complicating the
analysis. To gain further insights, the assumptions can be relaxed and more
robust results can be derived. The assumptions of the CAPM are as follows:
1) Risk-averse, utility-maximizing, rational investors
The model assumes investors to be risk-averse. However, the degree of risk
aversion may differ from one individual to another. We know that risk-averse
individuals need compensation for the risk they take. Systematic risk takes
care of the additional risk that risk-averse investor takes and compensates
them with higher returns. In addition to the risk aversion assumption, the
investor is a utility maximizer too as he always wants higher returns and
would not compromise on lower returns in his portfolio. As we know more is
always better, and a rational investor would always want more and more
wealth. Hence, he/she is never satisfied. By investors being rational, the
model assumes that they can correctly evaluate and analyze the available
information to make at correct decisions. The calculations by rational
investors may bring them to different estimates of expected risk and expected
returns but they will remain rational individuals. Even in economics, every
economic theory assumes consumers to be risk averse and utility maximizers.
This gives us a realistic view of the world which is generally accepted as
well.
2) Frictionless markets
Frictionless markets allow smooth functioning of the market and analysis of
the operational characteristics of such markets is abstract. In the absence of
transaction costs and taxes, the trading volume or the prices in the market do
not affect the risk-return relationship of the securities. In other words, it is
assumed that frictionless markets do not have any costs or restrictions on
short selling too. It also assumes that the rate at which borrowing and lending
take place in the market is the same and at the risk-free rate.
3) Investors plan for the same single holding period
The model assumes that the investors make decisions for one period only and
hence it is a single-period model. Working with a multi-period model is very
difficult and inconvenient. A drawback of the single period model is that it
does not allow investors to learn from past mistakes and bad decisions are
bound to persist. It may be possible that sub-optimal decisions are to be made
in single periods to achieve maximising outcomes in multi-period settings.
But it has been observed that the single holding period does not largely affect
232 the application of the CAPM to the multi-period horizon.
4) Investors have homogeneous expectations or beliefs Capital Asset
Pricing Model
All the investors are assumed to analyze assets using the same probability
distributions and the same inputs for future cash flows. Furthermore, they are
also assumed to be rational investors who arrive at the same valuations. As a
consequence of similar valuations of all assets, they will choose or produce
the same optimal risky portfolio or the market portfolio.
5) All investments are infinitely divisible
An individual is assumed to invest as little or as much as he or she wishes in
an asset. This allows the model to rely on continuous functions and discrete
jump functions can be avoided or excluded from the framework. The
assumption does not have any direct consequences on implications from the
model. It only makes the understanding of the model convenient for
investors.
6) Investors are price takers
There is a large number of investors and no investor is large enough to
influence prices in the market. The security prices are assumed to be
unaffected by the number of trades investors typically trade-in. Even though,
the prices of the small stocks may be affected by the investors but not large
enough to affect the primary estimates of the CAPM. Thus, investors are
price takers.

12.6.2 The security MarketLine & CAPM

The model can be applied to the pricing of various securities in different settings.
In this section, we will focus our attention on the application of CAPM in the
context of the security market line (SML). The SML is a graphical
representation of the capital asset pricing model with beta on the x-axis and the
expected return of the security on the y-axis. Similar to the capital market line,
the SML intersects the y-axis at the risk-free rate of return, and the slope of the
SML is defined by the market risk premium, Rm – Rf. In contrast to CML, SML
applies to individual securities rather than portfolios on the efficient frontier.
Recall that the efficient frontier reflects optimal combinations of expected return
and total risk for the investors. In other words, the security market line works for
all securities, whether efficient or not. In the case of efficient portfolios, the total
risk and systematic risk are equal because there is no scope for diversification of
risk any further.
Figure 3 shows a graphical representation of the security market line in the
CAPM framework. The beta of the market is 1.0 on the x-axis and the expected
rate of return (Rm) earned by the market is mentioned on they-axis. The points on
this line help to calculate the expected return of an asset based on systematic risk
only. The figure shows that at point M, the systematic risk of the market and the
security are the same which means that the expected returns from the security
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Asset Pricing will be the same as the expected returns from the market. The positive and linear
relationship between beta and expected return shows that an increase in the Beta
will increase the expected return from the security, given the risk-free rate in the
market.

E(Ri)

Expected Return
SML

M
E(Rm) βi= βm

Slope = Rm – Rf
Rf

1.0 βi
Beta
Figure 3: The Security Market Line

12.6.3 Applications of the CAPM

The predictive power of the CAPM regarding risk and the relationship between
risk and return makes it very powerful and appealing. There is a large number of
practical applications of the CAPM that may not be true from a theoretical
perspective. In this section, we will discuss the common applications of the
model. We will see that the CAPM and the SML took together will indicate the
direction of the market returns at the given level of risk under different situations.
However, the results may indicate that the actual return may be quite different
from the expected return which helps to evaluate whether a security is
overvalued, undervalued or fairly valued. Other major applications of the CAPM
include computation of the estimates of the expected return for capital budgeting,
the performance appraisal of the portfolio manager can also be done by
comparing the actual return of a portfolio and the CAPM return estimated by the
portfolio manager, and the output from the model also helps in the selection of
the security based on the analysis of alternate return estimates and the CAPM
returns.
For instance, we have calculated the expected return of the asset using CAPM
under the assumption of the given systematic risk of the asset. To value assets
such as stocks, bonds, real estate, and other financial assets, the estimate of the
expected rate of return derived from the CAPM is an important benchmark for
making an investment decision for that asset. Similarly, to determine the
234 economic feasibility of projects in the capital budgeting decision-making process,
the estimated required rate of return from the CAPM helps in choosing the right Capital Asset
Pricing Model
project for the company. Analytical tools of capital budgeting such as the net
present value of a project, investments and net revenues also require estimates of
cash flows which are discounted at the required rate of return. Depending on the
risk of the project, the required rate of return is estimated using the CAPM. It is
not surprising that the CAPM is used to estimate the expected return of the assets
in many scenarios. Such an example includes the computation of the cost of
capital for the companies regulated by regulatory commissions and setting fair
insurance premiums.

12.6.4 Limitations of the CAPM

Besides the usefulness of the CAPM, it is subject to theoretical and practical
limitations. Theoretical limitations refer to the problems which restrict the
estimated values of the model because of the inherent framework of the model,
whereas practical limitations of the model are faced by managers during the
implementation of the model.
[Link] Theoretical Limitations of the CAPM
In a single-factor model, only systematic risk or beta risk is used for the pricing
of the securities in the CAPM. Thus, no other features of the investment are
considered in estimating the returns of the asset. This makes the model very
restrictive and inflexible. In addition, the model is more prescriptive in nature
and popular because it is easy to understand and apply. The model does not make
predictions in the multi-period horizon and has no further implications regarding
the investment objectives of future periods. As a consequence, it has led to
myopic and suboptimal investment decisions.
[Link] Practical Limitations of the CAPM
Apart from the theoretical limitations, the practical implementation of the CAPM
raises some serious concerns which are listed below:
• True Market portfolio:
According to the CAPM theory, the true market portfolio is defined as the sum of
investible and non-investible assets of all kinds such as all asset classes, financial
and nonfinancial instruments, human capital and assets in closed economies.
Thus, it is difficult to test the estimates of the CAPM for some assets of the true
market portfolio which are not observable.
• Market portfolio Proxies:
In the absence of true estimates, different assumptions are made by the market
participants which produce proxies to estimate the expected return of the assets.
These proxies change depending on the assumptions made by the analysts, the
country of the investor, etc. And in turn, generate different return estimates for
the same asset. This is not permitted in the CAPM framework.
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Asset Pricing • Estimation of systematic risk:
Sufficient historical data is needed to estimate beta risk under CAPM. In some
cases, it is possible that the historical status of the company, may not be an
accurate and reliable representation of the recent or future state of the company.
The CAPM can be considered an ex-ante model. However, the estimates
obtained from the model are obtained using ex-post data. Thus, different periods
used for the estimation of results will produce different estimates of beta.
• Poor predictor of returns:
The empirical support for the reliability of the estimates of the CAPM is weak
when the estimate of asset returns is closely associated with realized returns. In
other words, empirical results or historical data do not support the hypothesis that
asset returns are determined only by systematic risk. The low predictive power of
the CAPM model is a serious limitation because investors make investments
based on their prediction of future returns.
• Homogeneity in investor expectations:
There is a single security market line under the CAPM because it assumes that
investor expectations are homogeneous and as a consequence, the model
generates a single optimal risky portfolio for the market and investors. By
relaxing this assumption, there will be many optimal risky portfolios and a large
number of security market lines. Thus, investors will use the same information as
rational decision makers and make choices between different optimal risky
portfolios.

Check Your Progress 2

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) Explain the assumptions of the CAPM model.
………………………………………………………………………………….
………………………………………………………………………………….
2) In what way does the CAPM model build upon Markowitz’s theory of
portfolio selection?
………………………………………………………………………………….
………………………………………………………………………………….
3) What are the practical and theoretical limitations of the model in the portfolio
theory.
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….

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 Capital Asset
12.7 LET US SUM UP Pricing Model

In this unit, we have discussed the concepts, assumptions and limitations of the
capital asset pricing model in detail which is very important in the estimation of
the asset returns based on the systematic beta. The unit also discussed other
related topics such as the capital market line and security market line. The
understanding of passive asset management strategy is very important for an
investor as market conditions define the use of investment strategies. The
investors usually lend and borrow at different rates to form a leverage market
portfolio and obtain a higher expected return. Next, we discussed the importance
of each type of risk namely, systematic and non-systematic risk and which one
can be avoided or not. The introduction to beta explains the estimation of the
sensitivity of the asset to market conditions. The model entails a relationship
between beta and expected return through its equation.

12.8 ANSWERS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) See section 12.3 and answer.
2) See section 12.3 and answer.
3) See section 12.4 and answer.

Check Your Progress 2

1) See section 12.5 and answer.
2) See sub-section 12.5.2 and answer.
3) See section 12.5 and answer.

Check Your Progress 3

1) See sub-section 12.6.1 and answer.
2) See sub-section 12.6.2 and answer.
3) See sub-section 12.6.4 and answer.

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Asset Pricing

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