Part1
TheCapitalAssetPricingModel
Monday: 7/24/2011
Chapter9 CAPMTheoryandInterpretation ReadChapter&startproblems
Tuesday: Moregraphicalanalysis,Examples Workonproblems
Wednesday: MoreExcel Workonspreadsheet
The CAPM
The CAPM is a model!
Assumptions (page 281):
(1) Many small investors price takers.
(2) One identical holding period.
(3) Investments are limited to traded financial assets (stocks, risk-free asset).
(4) No market frictions (no taxes, no transaction costs).
(5) All investors are rational mean-variance optimizers.
investors are rational mean
optimizers
(6) Homogeneous expectations all see the same E- space.
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The CAPM
The resulting equilibrium (pages 281-282)
(1) All investors hold a combination of M (the market portfolio) and the
risk-free asset.
(2) M is efficient.
(3) Comment about risk aversion
(4) The CAPM equation (9.9): E ri rf i E rM rf
RememberingChapter7
E
rf
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RememberingChapter7
E
rf
RememberingChapter7
E
rf
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RememberingChapter7
E
CapitalMarketLine(CML)
P
rf
RememberingChapter7
E
CapitalMarketLine(CML)
P
rf
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OptimalportfoliosmustliealongtheCML
E
CapitalMarketLine(CML)
P
rf
OptimalportfoliosmustliealongtheCML
E
CapitalMarketLine(CML)
P
rf
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TheMarketPortfolio (M) isefficient
E
CML
M:Theproportionofeachstockinthis
portfolioequalsthemarketvalueofthe
stockdividedbythesumofthemarket
valuesofallstocks.
(1) Everyonemusthavethesameproportion
ofeachriskyassetinP
(3) EveryoneholdsthesameriskyportfolioP
(2) Insum,thoseproportionsmustbethatof
themarketportfolioM.
M
P
rf
TheCAPM Equation
E ri rf i E rM rf
9.9
What does it say?
To understand we must recall the main result from Chapter 8:
2
2
2
p p M 2 p
8.10
Total Risk = Market Risk + Residual Risk
According to (9.9), E(ri) is a function of Market Risk, but not a function of
to (9
is function of Market Risk but not function of
Residual Risk.
(1) Eliminate residual risk (diversify)
(2) Control market risk according to risk tolerance.
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Nowwehavetwographs
TheSecurityMarketLine,SML
E ri rf i E rM rf
E
E
CML
SML
M
rf
rf
Slope E rM rf
TheCMLandtheSML
TheSecurityMarketLine,SML
E ri rf i E rM rf
E
E
CML
SML
E rM
M
E rM
M
rf
rf
M
M 1
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Alpha
E
E
CML
SML
positive
M
E rM
negative
rf
rf
SharpeRatio:slopeoftheCML
Rewardperunitoftotalrisk
S
Beta:degreeofmarketrisk
Alpha:verticaldeviationfromSML**
E ri rf i E rM rf
E rM rf
M
i E ri rf i E rM rf
CAPM
E
E
CML
Underpriced?
Good investment?
SML
positive
M
E rM
negative
Overpriced?
Bad investment?
rf
rf
E ri
E pit 1 pit
pit
if pit E ri
if pit E ri
8