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# Sess15 new_1 - Lecture 15 Capital Asset Pricing Model Reading RWJ Chapter 13 Outline Derivation of the CAPM The Security Market Line Properties of

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Fin3715 – Fall 07 – Kayhan 1 Lecture 15: Capital Asset Pricing Model Reading: RWJ Chapter 13 Outline : Derivation of the CAPM The Security Market Line Properties of Beta Alternatives to the CAPM

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Fin3715 – Fall 07 – Kayhan 2 Summary : Portfolio Theory (1) Assume: Investors maximize expected return while minimizing portfolio standard deviation, and Investors can borrow and lend at risk-free rate. Results: each investor’s optimal portfolio is a combination of only two portfolios The risk-free asset The market portfolio The market portfolio is the portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P 500, is often used to represent the market.
Fin3715 – Fall 07 – Kayhan 3 Summary: Portfolio theory (2) We analyze investors' asset demand given the distribution of asset returns. Investors hold portfolios to reduce risk (Diversification). ``Non-systematic risks'' of individual assets don't matter. Only ``systematic risks'' matter. Investors hold portfolios that has eliminated the unique risk and care only about portfolio risk. An individual asset's contribution to portfolio risk is its covariance with portfolio .

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Fin3715 – Fall 07 – Kayhan 4 A “Standardized” Measure of Market Risk for an Asset: beta ( ) If an individual asset's contribution to portfolio risk is its covariance with portfolio, then we can define as the “standardized” measure of market risk of asset “i” with respect to the market portfolio: The main intuition is that due to diversification, only non-diversifiable risk is priced. We often refer to β iM as β i to simplify notation. 2 iM σ σ ) var( ) , cov( β M iM M M i r r r = = β iM β
5 The Capital Asset Pricing Model (CAPM) The general relationship between the risk and return of an asset is therefore given by ) ( f M i f i r r r r - + = β CAPM : The CAPM is a model of assets’ risk-return tradeoff. In particular, the CAPM says that assets earn a risk premium proportional to the market risk premium , , where the constant of proportionality is the asset’s beta with respect to the market. f

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## This note was uploaded on 05/06/2008 for the course FIN 3715 taught by Professor Stephens during the Spring '08 term at LSU.

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Sess15 new_1 - Lecture 15 Capital Asset Pricing Model Reading RWJ Chapter 13 Outline Derivation of the CAPM The Security Market Line Properties of

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