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Unformatted text preview: Copyright 2006 Nelson Australia Pty Limited Chapter 8 Risky asset pricing models and the CAPM Learning objectives After the completion of this chapter, you should be able to: intuitively understand the: capital market line (CML) capital asset pricing model (CAPM) and the security market line (SML) apply the CAPM in pricing risky assets including shares use the CAPM to justify values for relevant parameters understand the importance of assumptions underlying the CAPM explain the difficulties associated with testing the CAPM debate whether the CAPM is an appropriate model to price risky assets Key points 1 CML prices efficient assets, while SML can be applied to both inefficient portfolios and assets and efficient portfolios. 2 In practice, CAPM difficult to apply due to Rolls critique. 3 Evidence supportive of at least a single factor. Chapter outline 8.1 Introduction 1 Fundamental question is the appropriate return for an asset. 2 The return on an asset should be commensurate with the risk of the asset. 8.2 The capital asset pricing model 1 The CAPM posits a linear relationship between expected return and risk. Risk is measured by the covariance with the market, known as beta. 2 Under the SML, only systematic risk is priced. 8.3 Using the CAPM 1 CAPM is a oneperiod model, hence issues when applying the model in practice. 2 These issues relate to identifying the riskfree rate, calculation of the expected risk premium and the calculation of beta. 2 Investments: Concepts and Applications Solutions Manual Copyright 2006 Nelson Australia Pty Limited 8.4 Testing the CAPM 1 Early tests of the CAPM find moderate support for the CAPM. The price of risk is positive, however, low beta stocks have returns higher than expected. 2 This finding lead to the beta is dead debate, whereby variables such as firm size were argued to subsume the relationship between expected return and beta. 8.5 Extensions to the CAPM 1 CAPM can be adjusted to take into account particular market conditions. For example, marketability of assets, borrowing and lending rates, normality of asset returns and taxes. 2 The CAPM has also been derived to cater for the imputation tax system that operates in Australia. Solutions to text problems Problems and applications 1 The capital market line (CML) is a line passing through the risk free rate of return, tangent to the opportunity set. In equilibrium investors choose that combination of the risk free asset and one risky portfolio which ensures the maximum expected return for any given variance. The set of portfolios which meets this requirement is described by the line drawn from the risk free rate of return on the vertical axis and extends to touch the opportunity set of risky assets at a tangency point. Investors then choose that combination of the risky portfolio and the risk free asset which maximizes utility (see figure 8.1, below)....
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