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The Capital Asset Pricing Model

It is the equilibrium model that underlies all modern financial theory.Derived using principles of diversification with simplified assumptions.Markowitz, Sharpe, Lintner and Mossin are researchers credited with its development.. Capital Asset Pricing Model (CAPM). Individual investors are price takers.Single-period investment horizon.Investments are limited to traded financial assets.No taxes and transaction costs..

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The Capital Asset Pricing Model

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    1. Chapter 9 The Capital Asset Pricing Model

    2. It is the equilibrium model that underlies all modern financial theory. Derived using principles of diversification with simplified assumptions. Markowitz, Sharpe, Lintner and Mossin are researchers credited with its development. Capital Asset Pricing Model (CAPM)

    3. Individual investors are price takers. Single-period investment horizon. Investments are limited to traded financial assets. No taxes and transaction costs. Assumptions

    4. Information is costless and available to all investors. Investors are rational mean-variance optimizers. There are homogeneous expectations. Assumptions (cont’d)

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

    6. Risk premium on the the market depends on the average risk aversion of all market participants. Risk premium on an individual security is a function of its covariance with the market. Resulting Equilibrium Conditions (cont’d)

    7. Capital Market Line

    8. M = Market portfolio rf = Risk free rate E(rM) - rf = Market risk premium E(rM) - rf = Market price of risk = Slope of the CAPM Slope and Market Risk Premium

    9. The risk premium on individual securities is a function of the individual security’s contribution to the risk of the market portfolio. An individual security’s risk premium is a function of the covariance of returns with the assets that make up the market portfolio. Return and Risk For Individual Securities

    10. Security Market Line

    11. ????????????????????= [COV(ri,rm)] / ?m2 Slope SML = E(rm) - rf = market risk premium SML = rf + ?[E(rm) - rf] Betam = [Cov (ri,rm)] / sm2 = sm2 / sm2 = 1 SML Relationships

    12. E(rm) - rf = .08 rf = .03 ?x = 1.25 E(rx) = .03 + 1.25(.08) = .13 or 13% ?y = .6 e(ry) = .03 + .6(.08) = .078 or 7.8% Sample Calculations for SML

    13. Graph of Sample Calculations

    14. Disequilibrium Example

    15. Suppose a security with a ? of 1.25 is offering expected return of 15%. According to SML, it should be 13%. Under-priced: offering too high of a rate of return for its level of risk. Disequilibrium Example (cont.)

    16. Black’s Zero Beta Model Absence of a risk-free asset Combinations of portfolios on the efficient frontier are efficient. All frontier portfolios have companion portfolios that are uncorrelated. Returns on individual assets can be expressed as linear combinations of efficient portfolios.

    17. Black’s Zero Beta Model Formulation

    18. Efficient Portfolios and Zero Companions

    19. Zero Beta Market Model

    20. CAPM & Liquidity Liquidity Illiquidity Premium Research supports a premium for illiquidity. Amihud and Mendelson

    21. CAPM with a Liquidity Premium

    22. Liquidity and Average Returns

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