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Foundations of Finance: The Capital Asset Pricing Model (CAPM)

Prof. Alex Shapiro

Lecture Notes 9

The Capital Asset Pricing Model (CAPM)
I. II. III. IV. V. VI. Readings and Suggested Practice Problems Introduction: from Assumptions to Implications The Market Portfolio Assumptions Underlying the CAPM Portfolio Choice in the CAPM World The Risk-Return Tradeoff for Individual Stocks

VII. The CML and SML VIII. “Overpricing”/“Underpricing” and the SML IX. X. Uses of CAPM in Corporate Finance Additional Readings
Equilibrium Process, Supply Equals Demand, Market Price of Risk, Cross-Section of Expected Returns, Risk Adjusted Expected Returns, Net Present Value and Cost of Equity Capital.

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Foundations of Finance: The Capital Asset Pricing Model (CAPM)

I.

Readings and Suggested Practice Problems
BKM, Chapter 9, Sections 2-4. Suggested Problems, Chapter 9: 2, 4, 5, 13, 14, 15 Web: Visit www.morningstar.com, select a fund (e.g., Vanguard 500 Index VFINX), click on Risk Measures, and in the Modern Portfolio Theory Statistics section, view the beta.

II. Introduction: from Assumptions to Implications
A. Economic Equilibrium 1. Equilibrium analysis (unlike index models) Assume economic behavior of individuals. Then, draw conclusions about overall market prices, quantities, returns.

2.

The CAPM is based on equilibrium analysis Problems:

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There are many “dubious” assumptions. The main implication of the CAPM concerns expected returns, which can’t be observed directly.

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Foundations of Finance: The Capital Asset Pricing Model (CAPM)

B. Implications of the CAPM: A Preview If everyone believes this theory… then (as we will see next): 1. There is a central role for the market portfolio: a. This simplifies portfolio selection. b. Provides a rationale for a “market-indexing” investment strategy.

2. There is

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