Chapter 9 - Chapter 9 Risk and Return Theories II CAPM...

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Chapter 9: Risk and Return Theories: II - CAPM predicts expected return an investor should require in order to acquire an asset I. Economic Assumptions Behavioral Assumptions 1) assumes investors make investment decisions based on expected return and variance of returns (referred to as two-parameter model ) - investor who faces a choice between two portfolios with same expected return will select the portfolio with lower risk 2) assumes risk-averse investor will ascribe to methodology of reducing portfolio risk by combining assets with counterbalancing correlations 3) assumes al investors make investment decisions over some single period time horizon 4) assumes investors have same expectations with respect to inputs used to derive Markowitz efficient portfolios ( homogenous expectations assumption ) Capital Markets Assumptions 1) capital market is perfectly competitive; no individual influence on asset’s price 2) assumes no transaction costs interfere with supply and demand for an asset 3) assumes a risk-free asset exists in which investors can invest II. Capital Market Theory - investor should create a portfolio with highest expected return for given level of risk that is measured by portfolio’s variance - introduction of risk-free rate means investors can borrow and lend at rate - tangent line to Markowitz efficient frontier represents all portfolios feasible to investor - portfolios to left of tangent point represent combinations of risky assets and risk- free assets - portfolios to right include purchases of risky assets made with funds borrowed - investor will select a portfolio on line representing combination of borrowing/lending at risk free rate and purchases of Markowitz efficient portfolio on tangent line Capital Market Line (CML) – line from risk-free rate to portfolio M on efficient frontier
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