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CHAPTER 7

CHAPTER 7. Capital Asset Pricing and Arbitrage Pricing Theory. Capital Asset Pricing Model (CAPM). CAPM is a theory of the relationship between risk and return CAPM underlies all modern finance. CAPM Assumptions. Information is costless and available to all investors

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CHAPTER 7

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  1. CHAPTER 7 Capital Asset Pricing and Arbitrage Pricing Theory

  2. Capital Asset Pricing Model (CAPM) • CAPM is a theory of the relationship between risk and return • CAPM underlies all modern finance

  3. CAPM Assumptions • Information is costless and available to all investors • Investors are ______________________ • Investors make ____________________ investment decisions • Homogeneous expectations

  4. CAPM Resulting Equilibrium Conditions • Investors will ________________ • All investors hold the same portfolio of risky assets – the market portfolio • Market portfolio contains all securities and the proportion of each security is its market value as a percentage of total market value

  5. Total Risk & Systematic Risk • Total Risk = Systematic + Firm-specific Risk Risk Because firm-specific risk can be eliminated by diversifying, the only risk that is relevant to diversified investors is systematic risk (measured by beta)

  6. Security Market Line • According to CAPM, the required return on a security (or portfolio) is shown by the Security Market Line (SML). • The SML relationship can be shown algebraically or graphically. rX = rf + BX (ERM – rf) Where rX = required return on X ERM – rf = Market risk premium

  7. Security Market Line r SML E(rM) rf ß ß = 1.0 M

  8. Sample Calculations for SML ERm = .11 rf= .03 bx= 1.25 rx = .03 + 1.25(.08) = ______________

  9. Market Equilibrium • The expected (or predicted) return for a security equals its required return only if the security is fairly priced; in other words, if a market equilibrium exists.

  10. Disequilibrium Example • Suppose Security X with a b of 1.25 has a predicted return of 15% • According to SML, its required return is 13% • X is underpriced in the market: it offers too high of a rate of return for its level of risk

  11. Figure 7.2 The Security Market Line and Positive Alpha Stock

  12. Disequilibrium Example • For Stock X, with a predicted return of 15% and a required return of 13%: aX = predicted return – required return = 15% - 13% = __________ • Stocks with positive alphas are undervalued. Their predicted returns plot above the SML.

  13. Estimating Betas • Stock betas are estimated using historical data on T-bills, a stock index and individual securities • Risk premiums for individual stocks are regressed against the risk premiums for the stock index • Slope is the beta for the individual stock

  14. Figure 7.4 Characteristic Line for GM

  15. Predicting Betas • The beta from the regression equation is an estimate based on past history • Betas exhibit a statistical property: • Regression toward the _______________

  16. CAPM • Limitations of CAPM: • Market Portfolio is not directly observable (Roll’s critique) • Research shows that other factors affect returns

  17. Fama French Three-Factor Model • Returns are related to three factors: • Size • Book value relative to market value • Beta Three factor model describes returns better than beta alone

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