Aswath Damodaran 80
Alternatives to the CAPM
The risk in an investment can be measured by the variance in actual returns around an expected return
E(R)
Riskless Investment Low Risk Investment High Risk Investment
E(R) E(R)
RCan be diversified away in a diversified portfolio isk that is specific to investment (Firm Specific) Cannot be diversified away since most assetsRisk that affects all investments (Market Risk)
- each investment is a small proportion of portfolio2. risk averages out across investments in portfolio are affected by it.
The marginal investor is assumed to hold a “diversified” portfolio. Thus, only market risk will be rewarded and priced.
The CAPM The APM Multi-Factor Models Proxy Models
I1. no private informationf there is
- no transactions costthe optimal diversified
portfolio includes everytraded asset. Everyone
will hold this Market Risk = Risk market portfolio
added by any investment to the market portfolio:
If there are no arbitrage opportunities
tahneyn atshsee mt marukset tb ries k of
captured by betas relative to factors that
aMarket Risk = Risk ffect all investments.
exposures of any asset to market
factors
Beta of asset relative toMarket portfolio (from
a regression)
Betas of asset relativeto unspecified market
factors (from a factoranalysis)
Smioncste o mr aalrl kinetv reissktm aeffnectst,s
imacro economic factors.t must come from
Market Risk = Risk exposures of any
asset to macro economic factors.
Betas of assets relativeto specified macro
economic factors (froma regression)
Idifferences in returnsn an efficient market,
across long periods mustbe due to market risk
differences. Looking forvariables correlated with
returns should then give us proxies for this risk.
Market Risk = Captured by the
Proxy Variable(s)
Equation relating returns to proxy
variables (from aregression)
Step 1: Defining Risk
Step 2: Differentiating between Rewarded and Unrewarded Risk
Step 3: Measuring Market Risk
Note that all of the models of risk and return in finance agree on the first two
steps. They deviate at the last step in the way they measure market risk, with
The CAPM, capturing all of it in one beta, relative to the market portfolio
The APM, capturing the market risk in multiple betas against unspecified
economic factors
The Multi-Factor model, capturing the market risk in multiple betas
against specified macro economic factors
The Regression model, capturing the market risk in proxies such as
market capitalization and price/book ratios
