091017_CAPM - Capital Asset Pricing Model (CAPM) Optimal...

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Capital Asset Pricing Model (CAPM)
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Optimal investment choice with the introduction of a risk-free asset
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Capital market line: CML z Portfolio A = Tangency portfolio: a rational investor will always choose such a portfolio of risky assets (A) that would allow him to get on the highest CML available z Equation of the CML is the following: () ( ) P A f A f P R R E R R E σ + =
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Capital market line: CML z Economic meaning of CML: A rational investor would require a compensation of for each additional percentage point of risk z CML shows the location of the most efficient portfolios: Portfolios with a maximum E(R) for any given level of risk Portfolios with a minimum level of risk for any given E(R) () A f A R R E σ
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Two fund separation theorem z A risk averse investor can form the optimal portfolio by combining just TWO funds: The risk-free asset The same (for all investors) risky portfolio A z Implications: All investors will hold identical portfolios of risky assets The distribution of funds between the risky and risk- free assets is determined by investor’s preferences
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This note was uploaded on 10/12/2010 for the course BANKING AN 001 taught by Professor Bogdukevich during the Fall '10 term at London Business School.

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091017_CAPM - Capital Asset Pricing Model (CAPM) Optimal...

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