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Lecture6

# Lecture6 - Lecture 6 Capital Asset Pricing Model Lecture 6...

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Lecture 6, BUS 136, Investments, UCR 1 Lecture 6 Capital Asset Pricing Model

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Lecture 6, BUS 136, Investments, UCR 2 The Capital Asset Pricing Model The CAPM is a centerpiece of modern finance that gives predictions about the relationship between risk & expected return We will first look at the concept of diversification.
Lecture 6, BUS 136, Investments, UCR 3 Diversification: Two-Asset Example: Suppose you hold two risky assets in your risky portfolio, IBM and GE. Let the fraction of IBM be w and the fraction of GE be (1- w ) If w = 1, you hold only IBM, If w = 0, you hold only GE, If w = .5, you have an equally weighted portfolio.

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Lecture 6, BUS 136, Investments, UCR 4 IBM GE Portfolio Random Return Expected Return Std deviation Correlation in Returns 0.02% 8.67% 0.95% 6.68% 0.2592 B R A R P R ? P σ ( 29 ? P R E The Two Asset Portfolio
Lecture 6, BUS 136, Investments, UCR 5 The expected return of the portfolio is simply: Hence, expected return on an equally weighted portfolio is: ( 29 ( 29 ( 29 B A P R E w R wE R E ) 1 ( - + = ( 29 % 49 . 0 % 95 . 0 5 . 0 % 02 . 0 5 . 0 = × + × = P R E The Two Asset Portfolio –Expected Return

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Lecture 6, BUS 136, Investments, UCR 6 The Two Asset Portfolio: Risk Risk is measured typically by the standard deviation. The standard deviation of a portfolio is not a simple sum of the individual assets’ standard deviations. Instead, it is the square root of variance given by: AB B A 2 B 2 2 A 2 2 p ) (1 2 ) (1 ρ σ σ σ σ σ - + - + = w w w w ( 29 t coefficien n correlatio the is , B A B A AB R R Cov where σ σ ρ =
Lecture 6, BUS 136, Investments, UCR 7 Diversification: Two-Asset The standard deviation of the 50%/50% portfolio is: The portfolio risk is lower than either individual asset’s because of diversification .

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Lecture6 - Lecture 6 Capital Asset Pricing Model Lecture 6...

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