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    Chapter Ten: The Capital Asset Pricing Model

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    vishal
    This document provides an overview of the Capital Asset Pricing Model (CAPM). It outlines the key assumptions of CAPM, including that investors are risk-averse and assets are infinitely divisible. It also describes the capital market line and how it represents the relationship between risk and return. Additionally, it defines the market portfolio and security market line. The security market line shows the expected return of individual securities based on their beta, which measures the volatility of a security relative to the market.

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    Chapter Ten: The Capital Asset Pricing Model

    Uploaded by

    vishal
    25 views20 pages
    This document provides an overview of the Capital Asset Pricing Model (CAPM). It outlines the key assumptions of CAPM, including that investors are risk-averse and assets are infinitely divisible. It also describes the capital market line and how it represents the relationship between risk and return. Additionally, it defines the market portfolio and security market line. The security market line shows the expected return of individual securities based on their beta, which measures the volatility of a security relative to the market.

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    This document provides an overview of the Capital Asset Pricing Model (CAPM). It outlines the key assumptions of CAPM, including that investors are risk-averse and assets are infinitely divisible. It also describes the capital market line and how it represents the relationship between risk and return. Additionally, it defines the market portfolio and security market line. The security market line shows the expected return of individual securities based on their beta, which measures the volatility of a security relative to the market.

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    25 views20 pages

    Chapter Ten: The Capital Asset Pricing Model

    Uploaded by

    vishal
    This document provides an overview of the Capital Asset Pricing Model (CAPM). It outlines the key assumptions of CAPM, including that investors are risk-averse and assets are infinitely divisible. It also describes the capital market line and how it represents the relationship between risk and return. Additionally, it defines the market portfolio and security market line. The security market line shows the expected return of individual securities based on their beta, which measures the volatility of a security relative to the market.

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    of 20

    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
    2

    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

    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

    THE CAPITAL MARKET LINE


    THE CAPITAL MARKET LINE

    CML

    rP
    M
    rfr

    P
    5

    THE CAPITAL MARKET LINE


    THE SEPARATION THEOREM
    James Tobin identifies:
    the division between the investment decision and
    the financing decision

    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

    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

    THE SECURITY MARKET LINE


    (SML)
    FOR AN INDIVIDUAL RISKY ASSET
    the relevant risk measure is its covariance with
    the market portfolio (i, 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

    THE SECURITY MARKET LINE


    (SML)
    THE SECURITY MARKET LINE
    rm rrf

    r rrf

    2
    m

    i ,m

    or r i r ( r r )
    rf
    2
    rf
    i,M

    where

    i ,M

    i,M

    2
    M
    10

    THE SECURITY MARKET LINE


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

    11

    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

    P ,M X i i ,M
    i 1

    12

    THE SECURITY MARKET LINE


    (SML)
    THE SECURITY MARKET LINE

    E(r)

    SML

    rM
    rrf

    13

    THE MARKET MODEL


    FROM CHAPTER 7
    assumed return on a risky asset was related to
    the return on a market index

    ri iI i1rI iI

    14

    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

    15

    THE MARKET MODEL


    MARKET INDICES
    the most widely used and known are

    S&P 500
    NYSE COMPOSITE
    AMEX COMPOSITE
    RUSSELL 3000
    WILSHIRE 5000
    DJIA
    16

    THE MARKET MODEL


    MARKET AND NON-MARKET RISK
    Recall that a securitys total risk may be
    expressed as


    2
    i

    2
    iI

    2
    i

    2
    i

    17

    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

    18

    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

    19

    THE MARKET MODEL


    MARKET AND NON-MARKET RISK
    Why partition risk?
    non-market risk
    not related to beta
    risky assets with larger amounts of I will not have
    larger E(r)

    According to CAPM
    investors are rewarded for bearing market risk not nonmarket risk

    20

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