EFN412 Lecture 02 - Click to edit Master subtitle style...

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Unformatted text preview: Click to edit Master subtitle style 9/15/10 EFN412 Advanced Part A Topic 2 (2) Portfolio Theory Required Reading: PBEHP 10th ed. Ch7 (7.6-7.7) Alternative Reading: PBEHP 9th ed. Ch.7 (7.6-7.7) Background Reading: RTCWJ 4th ed. Ch.11, 3rd ed. Ch. 11 11 9/15/10 Reading and Assumed Reading PBEHP 10th ed. Ch. 7 (7.6-7.7) PBEHP 9th ed. Ch. 7 (7.6-7.7) Assumed Knowledge Last week we looked at an introduction to risk and return. This provides a starting point for the study of CAPM (relies on work started in your introductory finance subject). It is important that you have revised your Topic 1 notes on the 22 9/15/10 Learning Objectives Assumptions of Capital Market Theory. The Risk-Free Asset in Capital Market Theory. Efficient Portfolios and the Capital Market Line (CML). Systematic and Unsystematic risk. Separation Theorem. CAPM, the Security Market Line (SML) and Beta. 33 9/15/10 ASSUMPTIONS OF CAPITAL MARKET THEORY 44 9/15/10 Introduction to Capital Market Theory Capital market theory extends portfolio theory and develops a model for pricing all risky assets. The final product is the capital asset pricing model (CAPM) which allows you to determine the required rate of return for any risky asset. When learning any theory in science, finance or economics, it is important to understand the set of assumptions that specifies how the world is expected to act. This allows the researcher to concentrate on developing a theory that explains how the world will respond to changes in 55 9/15/10 Assumptions of Capital Market Because capital market theory builds on the Markowitz portfolio model, it requires the same assumptions along with some additional ones. These eight assumptions are: 1. All investors are Markowitz efficient investors. 2. Investors can borrow or lend any amount of money at the risk-free rate. 3. All investors have homogeneous expectations, ie. they estimate identical probability distributions for future rates of return. 4. All investors have the same one-period time horizon, for eg. one month, one-year or ten years. 5. All investments are infinitely divisible which means that it is 66 9/15/10 Are the Capital Market First, relaxing many of the assumptions would have only a minor effect on the model and would not change its main implications or conclusions. Second, a theory should never be judged only on the basis of its assumptions but rather on how well it explains and helps us predict 77 9/15/10 THE RISK-FREE ASSET IN CAPITALMARKET THEORY 88 9/15/10 The Risk-Free Asset The risk-free asset is critical to asset pricing. The expected return on a risk-free asset is entirely certain, thus, the standard deviation of 99 = RF 9/15/10 Risk-Free Asset in the Real 10 US Government Treasury Bills (30 day T-bills)....
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EFN412 Lecture 02 - Click to edit Master subtitle style...

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