review - Capital Market Line Line from RF to L is capital...

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Unformatted text preview: Capital Market Line Line from RF to L is capital market line (CML) x = risk premium = E(R M ) - RF y = risk = M Slope = x/y = [E(R M ) - RF]/ M y-intercept = RF E(R M ) RF Risk M L M y x Capital Market Line Slope of the CML is the market price of risk for efficient portfolios, or the equilibrium price of risk in the market Relationship between risk and expected return for portfolio P (Equation for CML): p M M p RF ) R ( E RF ) R ( E - + = Security Market Line CML Equation only applies to markets in equilibrium and efficient portfolios The Security Market Line depicts the tradeoff between risk and expected return for individual securities Under CAPM, all investors hold the market portfolio How does an individual security contribute to the risk of the market portfolio? Security Market Line Equation for expected return for an individual stock similar to CML Equation [ ] RF ) R ( E RF RF ) R ( E RF ) R ( E M i M M , i M M i- + =- + = Security Market Line Beta = 1.0 implies as risky as market Securities A and B are more risky than the market Beta > 1.0 Security C is less risky than the market Beta < 1.0 A B C E(R M ) RF 1.0 2.0 0.5 1.5 SML Beta M E(R) Security Market Line Beta measures systematic risk Measures relative risk compared to the market portfolio of all stocks Volatility different than market All securities should lie on the SML The expected return on the security should be only that return needed to compensate for systematic risk E r Underpriced SML: E r = r f + (E rm r f ) Overpriced rf Underpriced expected return > required return according to CAPM lie above SML Overpriced expected return < required return according to CAPM lie below SML Correctly priced expected return = required return according to CAPM lie along SML SML and Asset Values CAPMs Expected Return-Beta Relationship Required rate of return on an asset (k i ) is composed of risk-free rate (RF) risk premium (...
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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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review - Capital Market Line Line from RF to L is capital...

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