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CHAPTER TEN

Learn about the assumptions of the Capital Asset Pricing Model (CAPM), the Capital Market Line (CML), and the Market Model. Understand how risk and return are related and how market and non-market risk affect investment decisions.

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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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