Lec4 - LECTURE 4 Capital Asset Pricing Model (CAPM) and...

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AF3316 Investments Shaojun (Shaun) Zhang, Ph.D. ASA School of Accounting and Finance The Hong Kong Polytechnic University LECTURE 4 LECTURE 4 Capital Asset Pricing Capital Asset Pricing Model (CAPM) and Model (CAPM) and Arbitrage Pricing Arbitrage Pricing Theory (APT) Theory (APT)
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4-2 AF3316 Lecture 4 Intuitions • Investors require higher return on riskier investments Required returns = risk-free rate + risk premium • Investors can reduce risk by holding a diversified portfolio – Eliminating the unsystematic risk, and – Leaving only the systematic risk • Since investors can get rid of unsystematic risk through diversification, the risk premium of individual assets must be computed according to their systematic risk (i.e. from a portfolio perspective)
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4-3 AF3316 Lecture 4 # Stocks in Portfolio 10 20 30 40 2,000+ Company Specific (Diversifiable) Risk Market Risk 20 0 Total Risk, σ p σ p (%) 35 Elimination of Unsystematic Risk through Diversification
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4-4 AF3316 Lecture 4 Capital Asset Pricing Model (CAPM) Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) and Arbitrage Pricing Theory (APT) provide means to compute risk provide means to compute risk premium for asset portfolios as well as premium for asset portfolios as well as individual assets. individual assets.
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4-5 AF3316 Lecture 4 Capital Asset Pricing Model (CAPM) • Developed in 1950s and 1960s by Markowitz, Sharpe, Lintner, and Mossin, among others • An equilibrium model that underlies all modern financial theory • Derived using principles of diversification with simplified assumptions
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4-6 AF3316 Lecture 4 Assumptions • Individual investors are price takers • Single-period investment horizon • Investments are limited to traded financial assets • No taxes, no transaction costs • Information is costless and available to all investors • Investors are rational mean-variance optimizers • Homogeneous expectations
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4-7 AF3316 Lecture 4 Predictions of CAPM • All investors will hold the same portfolio for 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 • Market portfolio is on the efficient frontier
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4-8 AF3316 Lecture 4 Figure 7.1 The Efficient Frontier and the Capital Market Line (CML)
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4-9 AF3316 Lecture 4 M = Market portfolio r f = Risk free rate E(r M ) - r f = Market risk premium E(r M ) - r f = Market price of risk = Slope of the CML Risk Premium of the Market Portfolio M σ σ
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AF3316 Lecture 4 Risk Premium of Individual Securities β i = [COV(r i ,r m )] / σ m 2 E(r m ) – r f = market risk premium stock i’s risk premium = β i [E(r m ) - r f ] stock i’s required return = r f + β i [E(r m ) - r f ] Beta measures an individual security Beta measures an individual security s s contribution to the risk of the market contribution to the risk of the market portfolio. portfolio.
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Lec4 - LECTURE 4 Capital Asset Pricing Model (CAPM) and...

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