Lecture_7_2010

Lecture_7_2010 - E4729 Financial Institutions Markets and...

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E4729 Financial Institutions, Markets, and Risk Lecture 7 CAPM & Risk Management July 28, 2010 Leo M. Tilman L.M.Tilman & Co. & Columbia University
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CAPM
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3 E4729 Financial Institutions, Markets, and Risk Capital Asset Pricing Model Portfolio selection problem = a special case of normative financial economics: investors are told what they ought to do CAPM is an example of an exercise in positive economics: “how things actually are in reality” (e.g., how assets are priced) Per Milton Friedman, recipient of the 1976 Nobel Prize in Economics: The relevant question to ask about the “assumptions” of a theory is not whether they are descriptively “realistic” for they never are, but whether they are sufficiently good approximations for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.
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4 E4729 Financial Institutions, Markets, and Risk Capital Asset Pricing Model Some of the assumptions behind the CAPM are also behind the normative approach to investing (e.g., portfolio selection). These assumptions are as follows: 1. Investors evaluate portfolios by looking at the expected returns and standard deviations of the portfolios over a one-period horizon. 2. Investors are never satiated, so when given a choice between two portfolios with identical standard deviations, they will choose the one with the higher expected return. 3. Investors are risk-averse, so when given a choice between two portfolios with identical expected returns, they will choose the one with the lower standard deviation. 4. Individual assets are infinitely divisible, meaning that an investor can buy a fraction of a share if he or she so desires. 5. There is a riskfree rate at which an investor may either lend (that is, invest) or borrow money. 6. Taxes and transaction costs are irrelevant. 7. All investors have the same one-period horizon. 8. The riskfree rate is the same for all investors. 9. Information is freely and instantly available to all investors. 10. Investors have homogeneous expectations, meaning that they have the same perceptions in regard to the expected returns, standard deviations, and covariances of securities.
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5 E4729 Financial Institutions, Markets, and Risk Capital Asset Pricing Model Everyone has the same information and agrees about the future prospects for securities. Implicitly this means that investors analyze and process information in the same way. The markets for securities are perfect markets , meaning that there are no frictions to impede investing. Potential impediments such as finite divisibility, taxes, transactions costs, and different risk free borrowing and lending rates have been assumed away. This approach allows the focus to change from how an individual should invest to what would happen to security prices if everyone invested in a similar manner.
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Lecture_7_2010 - E4729 Financial Institutions Markets and...

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