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CHAPTER TEN

CHAPTER TEN. THE CAPITAL ASSET PRICING MODEL. THE CAPM ASSUMPTIONS. NORMATIVE ASSUMPTIONS expected returns and standard deviation cover a one-period investor horizon nonsatiation risk averse investors assets are infinitely divisible risk free asset exists no taxes nor transaction costs.

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CHAPTER TEN

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  1. CHAPTER TEN THE CAPITAL ASSET PRICING MODEL

  2. THE CAPM ASSUMPTIONS • NORMATIVE ASSUMPTIONS • expected returns and standard deviation cover a one-period investor horizon • nonsatiation • risk averse investors • assets are infinitely divisible • risk free asset exists • no taxes nor transaction costs

  3. THE CAPM ASSUMPTIONS • ADDITIONAL ASSUMPTIONS • one period investor horizon for all • risk free rate is the same for all • information is free and instantaneously available • homogeneous expectations

  4. THE CAPITAL MARKET LINE • THE CAPITAL MARKET LINE (CML) • the new efficient frontier that results from risk free lending and borrowing • both risk and return increase in a linear fashion along the CML

  5. THE CAPITAL MARKET LINE CML THE CAPITAL MARKET LINE rP M rfr sP

  6. THE CAPITAL MARKET LINE • THE SEPARATION THEOREM • James Tobin identifies: • the division between the investment decision and the financing decision

  7. THE CAPITAL MARKET LINE • THE SEPARATION THEOREM • to be somewhere on the CML, the investor initially • decides to invest and • based on risk preferences makes a separate financing decision either • to borrow or • to lend

  8. THE MARKET PORTFOLIO • DEFINITION: the portfolio of all risky assets which contains • complete diversification • a central role in the CAPM theory which is the tangency portfolio (M) with the CML

  9. THE SECURITY MARKET LINE (SML) • FOR AN INDIVIDUAL RISKY ASSET • the relevant risk measure is its covariance with the market portfolio (si, M) • DEFINITION: the security market line expresses the linear relationship between • the expected returns on a risky asset and • its covariance with the market returns

  10. THE SECURITY MARKET LINE (SML) • THE SECURITY MARKET LINE or where

  11. THE SECURITY MARKET LINE (SML) • THE SECURITY MARKET LINE • THE BETA COEFFICIENT • an alternative way to represent the covariance of a security

  12. THE SECURITY MARKET LINE (SML) • THE SECURITY MARKET LINE • THE BETA COEFFICIENT • of a portfolio • is the weighted average of the betas of its component securities

  13. THE SECURITY MARKET LINE (SML) THE SECURITY MARKET LINE SML E(r) rM rrf b b =1.0

  14. THE MARKET MODEL • FROM CHAPTER 7 • assumed return on a risky asset was related to the return on a market index

  15. THE MARKET MODEL • DIFFERENCES WITH THE CAPM • the market model is a single-factor model • the market model is not an equilibrium model like the CAPM • the market model uses a market index, • the CAPM uses the market portfolio

  16. THE MARKET MODEL • MARKET INDICES • the most widely used and known are • S&P 500 • NYSE COMPOSITE • AMEX COMPOSITE • RUSSELL 3000 • WILSHIRE 5000 • DJIA

  17. THE MARKET MODEL • MARKET AND NON-MARKET RISK • Recall that a security’s total risk may be expressed as

  18. THE MARKET MODEL • MARKET AND NON-MARKET RISK • according to the CAPM • the relationship is identical except the market portfolio is involved instead of the market index

  19. THE MARKET MODEL • MARKET AND NON-MARKET RISK • Why partition risk? • market risk • related to the risk of the market portfolio and to the beta of the risky asset • risky assets with large betas require larger amounts of market risk • larger betas mean larger returns

  20. THE MARKET MODEL • MARKET AND NON-MARKET RISK • Why partition risk? • non-market risk • not related to beta • risky assets with larger amounts of seIwill not have larger E(r) • According to CAPM • investors are rewarded for bearing market risk not non-market risk

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