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lec08-CAPM - Fin406 Fall 2009 Smeal College of Business...

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Fin406 – Fall 2009 Smeal College of Business Penn State University 2/3/2010 ©2009 JingZhi Huang 1 Lecture 8 - CAPM Fin 406 - Fall 2009 Professor Jingzhi Huang Smeal College of Business Penn State University Copyright © 2009 JZH Motivation Evaluate Performance Trade Security Selection Asset Allocation Define Objectives and Constraints Develop Market Expectations •Return •Risk •Tax •Horizon •Economy •Markets •Risk-Return Model •Benchmark Portfolios •Risk-Return tradeoff •Fixed Income •Equity •Cash •Orders •Leverage •Margin •After-tax Returns •Risk •Risk-Adj. Ret. •Benchmarks 2 Capital Asset Pricing Model (CAPM) provides a method for determining the optimal portfolio relates the expected return on a single security to its risk (the beta) is an equilibrium-based asset pricing model that underlies modern financial economics developed by Treynor (1961), Sharpe (1964), Lintner (1965), and Mossin (1966) I. CAPM and Portfolio Theory The well-known CAPM is closely related to the portfolio theories of Markowitz and Tobin Recall that under the separation property, all (risk-averse) investors will hold the same risky portfolio the tangency portfolio Since the market is simply the aggregate of all 3 investors holdings, the sample ( tangency) portfolio held by everybody must be the market portfolio Market portfolio includes all securities trading in the market and is a market-cap weighted portfolio (like the S&P 500 index portfolio) So the market portfolio is an efficient portfolio (in a nutshell, this is the CAPM) Assumptions made in CAPM Investors are rational mean-variance optimizers Identical single-period investment horizon Homogeneous expectations (same E(r) 4 expectations (same E(r), σ , ρ ) Investing only in publicly traded securities No taxes or transaction costs Can borrow or lend at same risk-free rate II. CAPM as a Pricing Model Under the CAPM, a security’s expected return is: E[r] CAPM = r f + (E[r m ] - r f ) (1) where = Cov(r,r m )/( m ) 2
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