2005F_C49_Note04 - Capital Asset Pricing Model Part 1: The...

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Unformatted text preview: Capital Asset Pricing Model Part 1: The Theory Introduction • Asset Pricing – how assets are priced? • Equilibrium concept • Portfolio Theory – ANY individual investor’s optimal selection of portfolio ( partial equilibrium ) • CAPM – equilibrium of ALL individual investors (and asset suppliers) ( general equilibrium ) Our expectation • Risky asset i: • Its price is such that: E(return) = Risk-free rate of return + Risk premium specific to asset i An example to motivate Expected Return Standard Deviation Asset i 10.9% 4.45% Asset j 5.4% 7.25% E(return) = Risk-free rate of return + Risk premium specific to asset i CAPM’s Answers E(return) = Risk-free rate of return + Risk premium specific to asset i CAPM’s Answers • Specifically: Total risk = systematic risk + unsystematic risk CAPM says: (1)Unsystematic risk can be diversified away. Since there is no free lunch, if there is something you bear but can be avoided by diversifying at NO cost, the market will not reward the holder of unsystematic risk at all. (2)Systematic risk cannot be diversified away without cost. In other words, investors need to be compensated by a certain risk premium for bearing systematic risk. CAPM results E(return) = Risk-free rate of return + Risk premium specific to asset i M f Pictorial Result of CAPM E(R ) E(R ) R Security Market Line β = CAPM in Details: What is an equilibrium? CONDITION 1: Individual investor’s equilibrium: Max U • Assume: • [1] Market is frictionless => borrowing rate = lending rate => linear efficient set in the return-risk space [2] Anyone can borrow or lend unlimited amount at risk-free rate • [3] All investors have homogenous beliefs => they perceive identical distribution of expected returns on...
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This note was uploaded on 03/21/2010 for the course KNOWLEDGE 5654 taught by Professor Mr.david during the Spring '10 term at IESE Business School.

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2005F_C49_Note04 - Capital Asset Pricing Model Part 1: The...

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