FBE441_05_CAPM

FBE441_05_CAPM - FBE 441 Investments Prof. David Solomon...

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FBE 441 Investments Prof. David Solomon Lecture 5: Asset Pricing and the CAPM Markets in Equilibrium and the CAPM intuition The Capital Asset Pricing Model (CAPM) Readings: BKM chapters 9 and 10
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2 Lecture Outline: - Lecture 5 : - Markets in Equilibrium - The Capital Asset Pricing Model (CAPM) - Lecture 6: - Tests of the CAPM - The Value and Size Anomalies: The Fama-French 3 Factor Model - The APT Model
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3 Markets in Equilibrium - Portfolio Theory says that everyone should want to hold the same combination of the mean-variance efficient portfolio and the risk free rate - Between them investors must hold all the assets in the economy - If we formed a portfolio of all the assets in the economy, what would it look like? - Intuitively, what does this imply about the composition of the mean-variance efficient portfolio?
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4 Markets in Equilibrium (1) ARBITRAGE : Ex: Asset A: E(R A )=10%, σ (R A )=20% Asset B: E(R B ) = 10%, σ (R B ) = 20% Correl(A,B) = -1 Rf = 5% Portfolio P (w A =50%,w B =50%): E(Rp)= 10% σ (Rp)= 0 => You can create pure arbitrage : Borrow at Rf=5% (short-sell risk-free asset) Invest in P at 10% riskless … for as much as you want ! No risk , but positive payout ! …. Ex: http://www.analyticinvestors.com/
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5 Markets in Equilibrium Adjustment in Prices (and Returns): Go long on P => excess buying pushes prices of A & B up (reducing its expected return): E(R A ) ↓ and E(R b ) ↓ Go short on Rf => Excess borrowing pushes the price of risk-free asset down (increasing Rf) : Rf ↑ The pressure is alleviated only when arbitrage opportunity disappears. There should be no arbitrage possibilities (no free lunch) in equilibrium.
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6 Markets in Equilibrium (2) EQUILIBRIUM MARKET FORCES : Case I: What if everyone wants to short-sell (w<0) asset A? Excess selling pressure -> prices of A fall -> E(r A ) rise -> some people want to hold A Case II: What if everyone wants to buy (w>0) asset A? Excess buying pressure -> prices of A rise -> E(r A ) fall -> some people no longer want to hold the stock (some may even want to hold w<0)
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Markets in Equilibrium - So what determines a security’s expected return? - Suppose investors hold the market portfolio. When considering whether to buy or sell a stock, they prefer higher expected returns, and trade this off against variance. -
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FBE441_05_CAPM - FBE 441 Investments Prof. David Solomon...

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