Topic 7 CAPM_APT - Topic 7 CAPM and APT FIN 4504 2 Capital...

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Unformatted text preview: Topic 7: CAPM and APT FIN 4504 2 Capital Asset Pricing Model (CAPM) • Objective: To formalize the relationship between risk and expected return What determines prices and returns? • CAPM is derived using principles of diversification with simplifying assumptions • First proposed by William Sharpe. 3 Assumptions General idea : Individuals are as alike as possible. • All investors are rational mean-variance optimizers • Single, identical holding period • Same asset universe • Homogeneous expectations • No frictions in the capital market: – No taxes, no transaction costs – Investors are price-takers – No restriction on short-selling – Investors can borrow-lend at the risk-free rate 4 Implications • All investors choose to hold the market portfolio – Market portfolio includes all assets. – The optimal market portfolio is value-weighted • The optimal market portfolio is on the efficient frontier – Market portfolio = ORP CAL = CML • E(r M ) – r f = A * σ M 2 5 Expected Return of Individual Securities • Market price of (undiversifiable) risk is the same for all securities and portfolios: ( ) ( ) ( ) ... M f i f j f M i j E r r E r r E r r β β β--- = = = ( ) [ ( ) ] i f i M f E r r E r r β = +- If securities are fairly priced, then alpha = 0. Only systematic risk is priced! What matters is the portfolio risk. 6 Expected Return of Individual Securities: Examples Individual asset : MSFT • Suppose market risk premium = 9% Beta of MSFT = 1.6 T-bill rate = 5% ( ) [ ( ) ] MSFT f MSFT M f E r r E r r β = +- ( ) 0.05 1.6 0.09 0.194 19.4% MSFT E r = + × = → 7 Expected Return of Individual Securities: Examples Portfolio : MSFT & GM • Suppose market risk premium = 9% Beta of MSFT = 1.6 Beta of GM = 1.15 weight of MSFT = 60% weight of GM = 40% • Portfolio beta = ?...
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Topic 7 CAPM_APT - Topic 7 CAPM and APT FIN 4504 2 Capital...

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