Lecture2013 - Lecture 13 Risk & Return Theories II Cont. I....

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Lecture 13 I. CAPM continued The CAPM predicts that the expected return of security n will be a linear function of its “beta” E [ R n ] = R f + ¯ n f E [ R M - R F ] g Where the “beta” of security n is estimated via a linear regression of R n on the market return R M . ¯ n = cov ( R n; R M ) V ar ( R M ) The CAPM’s testable implication is the world portfolio of risky assets is mean-variance e¢cient. There- fore, the expected return of any asset is a linear function of that asset’s beta with the world portfolio. Of course the “world” portfolio of all risky assets would include some unobservable risky assets such as real estate and education. The test of the CAPM typically uses a proxy for the world portfolio. This proxy is generally a well diversi…ed portfolio of observable risky securities. If this proxy lies on the mean-variance e¢cient frontier, the test of the CAPM will be valid. A major empirical shortcoming of integration tests based on the CAPM is the need to make assumptions
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This note was uploaded on 04/12/2008 for the course ECON 435 taught by Professor Chabot during the Winter '08 term at University of Michigan.

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Lecture2013 - Lecture 13 Risk & Return Theories II Cont. I....

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