Chapter 6 The Capital The Capital Asset Pricing Model
Demand for Stocks and Equilibrium Prices Imagine a world where all investors face the same opportunity set Each investor computes his/her optimal (tangency) portfolio The demand of this investor for a particular firm’s shares comes from this tangency portfolio
Demand for Stocks and Equilibrium Prices (cont’d) As the price of the shares falls, the demand for the shares increases The supply of shares is vertical , fixed and independent of the share price The CAPM shows the conditions that prevail when supply and demand are equal for all firms in investor’s opportunity set
Equilibrium model that underlies all modern financial theory Derived using principles of diversification with simplified assumptions Markowitz, Sharpe, Lintner and Mossin are researchers credited with its development Capital Asset Pricing Model (CAPM)
THE CAPM ASSUMPTIONS NORMATIVE ASSUMPTIONS expected returns and standard deviation cover a one-period investor horizon nonsatiation risk averse investors assets are infinitely divisible risk free asset exists no taxes nor transaction costs
THE CAPM ASSUMPTIONS ADDITIONAL ASSUMPTIONS one period investor horizon for all risk free rate is the same for all information is free and instantaneously available homogeneous expectations
All investors will hold the same portfolio of risky assets – market portfolio Market portfolio contains all securities and the proportion of each security is its market value as a percentage of total market value The market portfolio is on the efficient frontier and, moreover, it is the tangency portfolio Resulting Equilibrium Conditions
Risk premium on the market depends on the average risk aversion of all market participants Risk premium on an individual security is a function of its covariance with the market Resulting Equilibrium Conditions (cont’d)
Capital Market Line E(r) E(r M ) r f M CML m
M = The market portfolio r f = Risk free rate E(r M ) - r f = Market risk premium = Slope of the CML Slope and Market Risk Premium M f M r ) r ( E
The risk premium on individual securities is a function of the individual security’s contribution to the risk of the market portfolio Individual security’s risk premium is a function of the covariance of returns with the assets that make up the market portfolio Expected Return and Risk on Individual Securities
The Risk of an Individual Asset1 Step 1: Individuals diversify and hold portfolios Step 2: The risk of a security is the risk it adds to the portfolio Step 3: Everybody holds the market portfolio Step 4: The risk of a security is the risk that it adds to the market portfolio.
The Risk of an Individual Asset2 Step 5: The covariance between an asset "i" and the market portfolio (Cov im ) is a measure of this added risk. The higher the covariance the higher the risk.
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