CAPITAL MARKET THEORY

CAPITAL MARKET THEORY - CAPITAL MARKET THEORY Objectives...

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CAPITAL MARKET THEORY Objectives Under capital market theory we examine three asset pricing models models that specify the behaviour of asset returns and the relation between the assets' risks and returns. These are: 1. The Capital Market Line (CML) 2. The Capital Asset Pricing Model (CAPM) 3. The Single Index Model (The Market Model or the ‘Security Characteristic Line’) At the end of this module, students should be able to clearly interpret each model, specifying the assumptions underlying each model, what each model represents about the behaviour of asset returns and in what circumstances each model is applicable. Students should also be aware of the uses to which each model can be applied and the strengths and weaknesses of each model . Relevant reading: BKM - Chapters  8, 9 Readings from the Articles Folder in Blackboard: 1. Regression Analysis.doc 2.  How to do regression analysis using EXCEL.pdf
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The sequence of topics discussed 1. The Capital Market Line 1. Portfolio diversification and the concept of beta risk 1. The Capital Asset Pricing Model  1. Index Models and the calculation of ex-post betas 1. The estimation of ex-ante betas
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The Capital Market Line (CML) The CML is derived from Markowitz Portfolio Theory. The CML gives the relation between the returns and risks of efficient portfolios and is a model that can be used to price efficient portfolios. Derivation of the CML Recall our framework for optimal portfolio selection in a universe of risky assets and the risk free asset, R f . The investor will prefer portfolios with higher utility than Q (such as S) by selecting a portfolio on the line R f Z. Portfolios on R f Z can be achieved by forming a linear combination between R f and the (risky) tangent portfolio T. Linear combinations result because R f is a risk free asset. The portfolio of risky assets our investor will now wish to hold is T rather than portfolio Q. Portfolios between the points R f and T represent positive weights invested in the risk free asset (lending) and in T while points from T to S represent negative weights on the risk free asset (borrowing) and over 100% weight on the tangent portfolio. E(r) std.deviation . . . . . . . . . . . X Y Q Rf S T Z
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2. Assume that all investors have homogeneous expectations Every investor sees the same efficient frontier and so, every investor will invest in T. Then T becomes M, the portfolio of all risky assets. This is called the market portfolio . We now have the result that every investor will invest part of their wealth in the market portfolio and the balance in R f in order to reach their optimal portfolio on the R f T line. Since every investor holds a portfolio on the line R
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This note was uploaded on 03/23/2011 for the course FIN 301 taught by Professor 3213 during the Three '11 term at Curtin.

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CAPITAL MARKET THEORY - CAPITAL MARKET THEORY Objectives...

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