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Unformatted text preview: 91THE CAPITAL ASSET PRICING MODELCHAPTER 992Outline of the Chapter•CAPM– What is CAPM?– Assumptions of CAPM– Market Portfolio in CAPM– CAPM equation– Security Market Line•Extensions of CAPM– The ZeroBeta Model– Labor Income– Multiperiod Model– A Consumption Based CAPM– Liquidity included CAPM•Differences and similarities between CAPM and the Index Model (will be discussed later)93The Capital Asset Pricing Model•CAPM is a cornerstone of modern financial theory•CAPM shows the relationship between risk of an asset and its expected return– Developed by Sharpe (1964), Lintner(1965) and Mossin (1966)•The CAPM provides– A benchmark rate of return for evaluating possible investments• i.e. Whether the expected return of the stock is more or less than its “fair” return given its risk– Help to make an educated guess as to the expected return on assets that have not yet been traded in the marketplace• i.e. Pricing an IPO94The Capital Asset Pricing Model (Continued)•Assumptions– Assumptions are employed to guarantee the similarity between different people with the exception of initial wealth and risk aversion.1.Individual investors are price takersIndividuals act as though security prices are unaffected by their own trades. The wealth of a single investor is so small compared to the total wealth in the economy95The Capital Asset Pricing Model (Continued)2. Single –period investment horizon Investor plan for one identical holding period They ignore everything that might happen after the end of the single period horizon3. Investments are limited to publicly traded financial assets, such as stocks and bonds, and to riskfree borrowing or lending arrangementsRules out investment in nontraded assets such as human capitalInvestor may borrow or lend any amount at a fixed, riskfree rate96The Capital Asset Pricing Model (Continued)4. Investors pay no taxes on returns and no transaction costs (commissions and service charges) on trades in securitiesInformation is costless and available to all investors5. Investors are rational meanvariance optimizersAll investors use the Markowitz portfolio selection model (optimal P on efficient frontier)97The Capital Asset Pricing Model (Continued)6. There are homogeneous expectationsAll investors analyse the securities in the same way and share the same economic view of the worldThe input list of Markowitz model is same for all investors. Given a set of security prices and the riskfree rate, all investor use the same expected returns and covariance matrix of security returns to generate the efficient frontier and the unique optimal risky portfolio98The Capital Asset Pricing Model (Continued)•Resulting equilibrium conditions:– All investors will choose to hold a portfolio of risky assets in proportions that duplicate representation of the assets in the market portfolio, M, which includes all traded assets• The proportion of each stock (asset) in the market portfolio=market value of the stock (price per share...
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This note was uploaded on 04/03/2010 for the course FEAS 311.01 taught by Professor Attilaodabaşı during the Spring '10 term at Boğaziçi University.
 Spring '10
 AttilaOdabaşı

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