17-CAPM1

17-CAPM1 - CapitalAssetPricingModel BKM:Chapter7...

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Capital Asset Pricing Model BKM: Chapter 7
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Optimal Portfolios Given current expected returns, standard  deviations, and correlations: Choose risky portfolio to maximize Sharpe ratio. Tailor the risk by investing (long or short) in the risk- free asset. This is the right approach whether or not markets  are “efficient”.
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Beating the Market Beating the market means more than earning a  higher average return You could do this by simply investing in small-cap  stocks. Beating the market means developing a  portfolio with a higher Sharpe ratio.
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Beating the market To beat the market: you should continually be  searching for stocks such that E[r]>r f + β  (E[r M ]-r f  )  tilt towards these E[r]<r f + β  (E[r M ]-r f  ) tilt away from these By tilting  the market portfolio  as above, you  increase the Sharpe ratio of the portfolio.
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Asset Pricing Easiest to think of “one-period” model: All companies are expected to operate for one year. At year-end, all companies will liquidate and distribute  all proceeds to investors. We don’t know what the value of each company’s assets  will be at year-end. We form some forecast, E[Get i ], of what will be given per  share to shareholders of company  i .
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Efficient Markets If markets are efficient Returns follow a “constant + white noise” process We can’t predict “ ε ” – our best guess is zero k i  is the expected return for company  i . Why is k different across stocks? i i i i k Get ε + = - 1 Price
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Holding E[Get] constant, A higher price implies a lower k. As lower price implies a higher k. Why do some stocks have  high  k’s? Why do some stocks have  low  prices relative to E[Get]? These stocks are apparently  unattractive  to investors: the expected  return needs to be high to entice investors to buy. Why do some stocks have  low  k’s? Why do some stocks have  high  prices relative to E[Get]? These stocks are apparently very  attractive  to investors: investors are  willing to buy these,  despite  their low expected returns. 1
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This note was uploaded on 03/17/2011 for the course BUS M 401 taught by Professor Toddmitton during the Fall '10 term at BYU.

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17-CAPM1 - CapitalAssetPricingModel BKM:Chapter7...

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