Chapter7 - Chapter 7 CAPITAL ASSET PRICING MODEL(CAPM 1...

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Chapter 7 CAPITAL ASSET PRICING MODEL (CAPM) 1
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Capital Asset Pricing Model Capital asset pricing model (CAPM) : Model that relates equilibrium expected return of a security to its risk measured by beta. CAPM generates a benchmark return to (1) evaluate possible investments, (2) value assets that have not yet been traded. 2
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CAPM assumptions Assumptions of CAPM: Investors are price-takers. Holding period is identical for all investors. Portfolios are formed from publicly traded financial assets. There is unlimited access to risk-free borrowing and lending. There are neither taxes nor transaction costs. Investors are rational mean-variance optimizers. Investors have homogenous expectations. 3
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CAPM implications (I) Implications of CAPM: Market portfolio is on the efficient frontier and is the optimal risky portfolio. Therefore, all investors choose to hold the market portfolio. Assumptions guarantee that all investors hold identical risky portfolios while price adjustment guarantees that that risky portfolio is the market portfolio. Mutual fund theorem : All investors desire the same portfolio of risky assets and can be satisfied by a single mutual fund composed of that portfolio. 4
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CAPM implications (II) Implications of CAPM (cont’d) : - Risk premium of the market portfolio will be proportional to the variance of the market portfolio and investors’ typical degree of risk aversion.
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