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CHAPTER 7

CHAPTER 7. Capital Asset Pricing Model. 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 Investors are risk averse

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CHAPTER 7

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  1. CHAPTER 7 Capital Asset Pricing Model

  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 risk averse • Investors make optimal investment decisions • Homogeneous expectations

  4. CAPM Resulting Equilibrium Conditions • Investors will diversify • All investors hold the same portfolio of risky assets – the market portfolio • Market portfolio contains all available in the market

  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 = 14% rf = 6% bx = 1.20 rx = 6 + 1.20(8) = 15.6%

  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 1.2 has a predicted return of 17% • According to SML, its required return is 15.6% • 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 17% and a required return of 15.6%: aX = predicted return – required return = 17% - 15.6% =1.4% • Stocks with positive alphas are undervalued. Their predicted returns plot above the SML.

  13. Estimating Betas • Stock betas are estimated using historical data on a stock index and individual securities • Returns for individual stocks are regressed against the returns 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 mean

  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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