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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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