Lecture Notes 5 CAPM - The CAPM The The CAPM: An asset...

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Unformatted text preview: The CAPM The The CAPM: An asset pricing model An Prescribes a method of determining the Prescribes relationship between risk and equilibrium expected returns expected s An equilibrium model An s Assumptions Assumptions • • • • • • • Perfect Capital markets Investors are mean-variance optimizers Costless Information Homogeneous expectations Single period investment horizon Atomistic participants Borrowing and lending at the risk-free rate Principal result Principal s The market portfolio is an efficient The portfolio portfolio – The market portfolio is the optimum point in The the risk-return space along the efficient frontier Implications of the efficiency of the market portfolio the • All investors will hold the market portfolio • Risk premium on an asset will be Risk proportional to the market risk premium and to the asset beta computed with respect to the market portfolios to The risk-return relationship The s E (ri ) − rf = β i ( E (rm − rf ) ) The second implication of the model (ref: The previous slide) yields the security market line (SML) relationship (SML) The Security Market Line The Expected Return Underpriced Securities Security Market Line - alpha E(Market Return) A B Risk-free Return + alpha Overpriced Securities Beta of the Market = 1.00 Beta The SML The – The Security Market Line (SML) graphically represents the expected returns - β relationship – SML is plotted in beta/return space as opposed to being plotted in standard deviation/return space (as in the CAL). – The SML reflects the insight that in equilibrium, only nondiversifiable (market) risk should be priced. Applications of the CAPM Applications Pricing of non-traded assets s Capital Budgeting Can one use the SML relationship to evaluate Can portfolio manager performance? portfolio s How to operationalize CAPM How Define a risk-free asset such as T-Bills s Select a market index or benchmark such as the S&P500 s Derive estimates of asset (or portfolio) betas s – Use linear regression (security characteristic line) Security Characteristic line Security Excess Return on Asset Distance from the line to the points are the error terms. Characteristic Line Beta for the firm is the slope of this line. Jensen Alpha for the firm is the intercept of this line. Excess Return on Market Empirical Validity of the CAPM? Empirical Tests based on ex-post returns s Classic test based on the regression: s ~~ ~ − r =α + β λ + ε rp f ˆ p ˆ p p i Null Hypothesis : λ p = 0 Difficulties with testing CAPM: Difficulties Roll’s critique True Market portfolio cannot be observed s Validation of the relationship outlined in Validation previous slide simply means that the proxy was mean-variance efficient was s And conversely, .... s As a consequence, SML should not be used As for performance evaluation s ...
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This note was uploaded on 09/27/2010 for the course BUSINESS 6F:111 taught by Professor Tongyao during the Spring '09 term at University of Iowa.

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