Chapter 3
Risk and Return:
Part II
ANSWERS TO BEGINNINGOFCHAPTER QUESTIONS
We do not normally cover the material in Chapter 3 in depth in our
intermediate financial management course—this treatment is reserved for the
investments course—but it is useful for students to recognize that the CAPM
results were derived under some restrictive assumptions and hence the derived
equations do not necessarily describe how returns are established in the real
world.
31
In finance theory, the value of an investment is found as the PV of the
asset’s expected stream of cash flows.
The CAPM is an “asset pricing
theory” that specifies how the discount rate in the valuation equation
should be determined.
Although the theory is quite complex and has
many component parts, it’s “bottom line” is the SML equation, often
called the CAPM equation:
r
s
= r
rf
+ b(r
m
– r
rf
)
The CAPM is the product of a number of different researchers, but
its principal developer was William Sharpe.
Sharpe was a UCLA doctoral
student employed by Rand Corporation in the early 1960 while he worked
on his dissertation.
Harry Markowitz, who in the early 1950s had
developed the concept of efficient portfolios as illustrated in Figure
33 and Equation 35, also worked at Rand, and he helped Sharpe
formulate his ideas.
Sharpe expanded Markowitz’s portfolio theory to
include the riskless rate of return and thus the CML as shown in Figure
37.
Sharpe also recognized that the “relevant risk” of any individual
stock could be measured by its beta coefficient, and thus he developed
the SML as shown back in Figure 212 and Equation 29.
A number of simplifying assumptions, including the following, were
made in order to derive the CAPM:
1.
Investors focus on a single holding period.
2.
Investors can borrow or lend unlimited amounts at the riskless
rate.
3.
Investors have homogeneous expectations regarding the returns of
different assets.
4.
There are no transactions costs.
5.
There are no taxes.
6.
The buy/sell decisions of any single investor do not influence
market prices.
Since these assumptions are not true in the real world, the SML
equation may not be correct, i.e., investors may not establish discount
rates in accordance with the CAPM.
Sharpe and Markowitz received the Nobel Prize for their work, which
has had a profound effect on the finance profession.
Answers and Solutions:
3  1
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32
Covariance shows how two variables move in relation to one another.
There are different “states of nature,” each with a probability of
occurrence, and a return on each asset under each state.
This
probability data can be used to determine the SD of returns for each
asset, the variance of those returns, and the correlation between
returns on the different assets.
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 Spring '09
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 Capital Asset Pricing Model, Modern portfolio theory

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