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Unformatted text preview: 21. d The Capital Asset Pricing Model (CAPM) Overview: One of the most fundamental processes involved with the investment of wealth is personal portfolio selection. Each portfolio consists of all assets and liabilities that are held by a given individual (or any other invested entity). It is very important to understand at the onset of choosing a portfolio that there is no single portfolio that is best for everyone. Investment decisions are merely a matter of risk-reward trade-offs, or the trade-off between risk and expected return (see Fig. 21.d.1). Because each individual has a different time horizon and risk tolerance, of which the former has a direct influence upon the latter, there will be many preferred portfolios out there that are unique for each investor. G F E D C B A 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.1 0.2 0.3 Standard Deviation Expected Return Figure 21.d.1. This is a risk-reward trade-off line. Point A shows a portfolio consisting entirely of riskless assets. The expected rate of return (r f ) for this riskless asset portfolio is 4% per annum and the deviation, and hence variance, is 0. Point G shows a portfolio consisting entirely of risky assets. The expected rate of return is 16% with a standard deviation (risk measurement) of .30. Points B through F are various combinations of risky and riskless assets with corresponding s.d. and expected returns. Point D, for example, is a portfolio consisting of 50% risky and 50% riskless asset holdings. Ultimately, the CAPM is used to establish both a methodology for finding preferred portfolios and for their subsequent management. The fundamental idea is that the market will reward people for bearing risk when holding efficient portfolios (diversified) corresponding to their particular level of risk-averse behavior. The market will not however reward holding inefficient portfolios. The nice thing about CAPM, as will become evident below, is that it makes for passive portfolio strategies, which simplifies portfolio choice by standardizing risky asset allocation to a single market portfolio. 21.d.i Portfolio Choice In its most simplistic terms, CAPM recognizes that each portfolio will consist of some combination of risk- less assets and risky assets and that an investor can choose how much to invest in each of these two types of assets. Graph 21.d.1 presented above represents a standard view of the options for riskless assets. However, the risk- reward trade-off curve for only risky assets can be seen below in Figure 21.d.2. H I J K 0.05 0.1 0.15 0.2 0.25 0.1 0.2 0.3 0.4 Standard Deviation Expected Return Figure 21.d.2. This is a risk-reward trade-off curve for risky assets only. The curve represents different possible risky asset portfolios. Point I is a minimum-risk point (lowest standard deviation). Points above this point trade risk for the potential for reward (expected return). Note that in reality, any risky asset portfolio on the curve that lies below point I will not ever be taken. that in reality, any risky asset portfolio on the curve that lies below point I will not ever be taken....
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This note was uploaded on 09/25/2008 for the course ECON 160 taught by Professor Baim during the Summer '98 term at UCLA.
- Summer '98