03 L3 - Lesson 3: Overview When you complete Lesson 3, you...

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Lesson 3: Overview When you complete Lesson 3, you will be able to extend your knowledge of market and portfolio analysis to a combination of portfolios in which the investor holds a risk free portfolio and a risky portfolio and varies the proportion of each to reflect the preferred risk aversion. Capital Asset Pricing Model (CAPM) How much return is required to compensate for a given degree of risk? The theoretical model is called the Capital Asset Pricing Model (CAPM). The CAPM is an equilibrium model specifying the relationship between risk and required return on assets held in well diversified portfolios. Basic Assumptions of the CAPM: 1. All investors think in terms of a single period. 2. All investors have the same expectations. 3. Investors can borrow or lend unlimited amounts at the risk free rate, and there are no restrictions on short sales of any asset. 4. All assets are perfectly divisible. 5. There are no taxes or transactions costs. 6. All investors are price takers, i.e. can't influence the stock prices. 7. Quantities of all assets are given and fixed. What is a short sale? You borrow stock and sell it. You must put up half the amount in cash. If the price goes up, you lose. If the price goes down, you win. The next topic is The Capital Market Line (CML) .
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Investors can create portfolios that combine the risk-free asset with a portfolio of risky assets. The straight line connecting k RF with M, the tangency point between the line and the efficient set becomes the new efficient frontier. Line k RF M Z = linear combinations of risky assets with the risk free asset. Any points below the line are inferior; therefore, utility maximizing investors pick a point on the line Question What does the CML tell us? Answer The expected rate of return on any efficient portfolio is equal to the risk free rate + risk premium. The risk premium is equal to (k M - k RF )/s M multiplied by the portfolio's standard deviation, s p . CML specifies that a linear relationship exists between risk and return. We
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This note was uploaded on 05/12/2010 for the course BUSINESS BS515 taught by Professor Johnson during the Fall '09 term at Drexel.

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03 L3 - Lesson 3: Overview When you complete Lesson 3, you...

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