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Unformatted text preview: Lecture 11 Review of CAPM Single I ndex Model 1 CAPMwhat is it? CAPM predicts the relationship between the expected return on the security and its risk Beta a measure of the assets covariance with the overall market is the correct measure of risk for any asset The market portfolio is the common risky portfolio (One Mutual Fund theorem) that all investors hold CAPM The fair risk premium on asset i: Define the assets beta as the contribution of the stock i to the variance of the market portfolio Finally we obtain: ] ) ( [ ) , ( ) ( 2 f m m m i f i r r E r r Cov r r E = 2 ) , ( m m i i r r Cov = ] ) ( [ ) ( f i f i r r E r r E m = 01 . * ) , ( } { A r r Cov r r E m i f i = Security Market Line SML exhibits the expected return beta relationship: SML graphs the individual asset risk premiums as a function of asset risk (beta). Given the risk of an investment, SML provides the required rate of return for that investment. Slope is equal to the risk premium of the market portfolio. 4 M Security Market Line SML exhibits the expected return beta relationship: Fairly priced assets would be located exactly on the SML. I f a stock is a good buy (i.e. underpriced), it would provide an expected return in excess of the fair return described by the SML. positive alpha stocks are a good buy 5 Security Market Line Notice, if alpha > 0, everyone wants to buy Notice, if alpha < 0, everyone wants to sell Hence price is not in equilibrium unless alpha = 0 6 Risk pr emium on an individual asset is pr opor tional to the r isk pr emium on mar ket por tfolio and the secur ity's beta. E{r e } r f = e [E{r m }  r f ] This r elationship defines the Secur ity M ar ket Line I mplications of the Capital Asset Pr icing M odel 1 Security Market Line . r f E{r} E{r m } Slope = E{r m }  r f 2 ) , ( m m e e r r Cov = I mplications of the Capital Asset Pr icing M odel Risk pr emium on an individual asset is pr opor tional to the r isk pr emium on mar ket por tfolio and the secur ity's beta. E{r e } r f = e [E{r m }  r f ] This r elationship defines the Secur ity M ar ket Line Suppose r f = 5%, e = 0.5, and the mar ket r isk pr emium (E{r m }  r f ) is 8%. Fill out the missing values 1 Security Market Line ? E{r} ? Slope = E{r m }  r f 0.5 ? I mplications of the Capital Asset Pr icing M odel Risk pr emium on an individual asset is pr opor tional to the r isk pr emium on mar ket por tfolio and the secur ity's beta. E{r e } r f = e [E{r m }  r f ] This r elationship defines the Secur ity M ar ket Line Suppose r f = 5%, e = 0.5, and the mar ket r isk pr emium (E{r m }  r f ) is 8%....
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 Spring '08
 Yusim
 Economics

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