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Class Note 7_S2010 - RSM 330 I nvest ment s Class 8 M aur...

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RSM 330 - Investments Class 8 – July 29, 2010 Maureen Stapleton,CFA 1 RSM 330 - Week 8 Stapleton
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Class Note 7 – CAPM & Multifactor Models CAPM – The Capital Asset Pricing Model Derivation & rationale Estimating Beta Practical Applications Factor Models of Risk & Return Fama & French three factor model Testing CAPM – does it work? What are the implications? I mportant: Read Prof Wang’s note on Multifactor Models (posted) RSM 330 - Week 8 Stapleton 2
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Risk and Return CAPM answers two important questions How to measure risk? How to quantify the relationship between return and risk? CAPM has 3 important applications: Valuation & Security selection Performance Measurement CAPM is based on modern portfolio theory (MPT) . Everyone holds a combination of the Market Portfolio & the riskless asset. Risk is the covariance of a risky asset with the market portfolio Expected return is linear with the covariance. RSM 330 - Week 8 Stapleton 3
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Market Portfolio will be used in the CAPM Everyone holds the market portfolio and the riskless asset. It follows directly from the separation principle . Riskless borrowing and lending are offset in the aggregate portfolio. S E R f Tangency portfolio = Market Portfolio CA L Optimal portfolios of individual investors 4 RSM 330 - Week 8 Stapleton
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Security Market Line (SML) Asset 1 Market Portfolio Asset 2 5 RSM 330 - Week 8 Stapleton
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Key Points about CAPM: The risk of a security is its covariance with the market portfolio. 6 RSM 330 - Week 8 Stapleton ) ( ) , ( M M i i r Var r r Cov = β The CAPM equation is: ( 29 f M i f i r r E r r E - = - ) ( ) ( β Compensation for risk = amount of risk ( β i ) x market M f
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7 Key points: What are the intercept and the slope of SML? What are the differences between the Capital Allocation Line (CAL) versus Security Market Line (SML). Do you expect all securities to plot on the SML? By definition , - the Beta of the market is 1 - The Beta of the risk free asset is 0 The Security Market Line (SML) RSM 330 - Week 8 Stapleton
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8 A stock sells for $60 per share today. Suppose that the riskless rate is 7% over the next year, and the expected market return is 17%. The stock return has a correlation of 0.8 with the market return, but the variance of the stock return is only a quarter (1/4) of the variance of the market return. The stock will pay a dividend of $4 per share at the end of the year. (a) What is the beta of this stock? (b) What do investors expect the stock to sell for at the end of the year? Applications of CAPM: A Past Exam Question RSM 330 - Week 8 Stapleton
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Solution: (a)By definition We know that Thus Next: We use the value of beta & the CAPM equation to calculate the expected return on the stock RSM 330 - Week 8 Stapleton 9 M i M i σ σ σ σ 5 . 0
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