Class Note 7_S2010 - RSM 330 - I nvestments Class 8 July...

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Unformatted text preview: RSM 330 - I nvestments Class 8 July 29, 2010 Maureen Stapleton,CFA 1 RSM 330 - Week 8 Stapleton Class Note 7 CAPM & M ultifactor M odels CAPM The Capital Asset Pr icing M odel Der ivation & r ationale Estimating Beta Pr actical Applications Factor M odels of Risk & Retur n Fama & Fr ench thr ee factor model Testing CAPM does it wor k? What ar e the implications? I mpor tant: Read Pr of Wangs note on Multifactor Models (posted) RSM 330 - Week 8 Stapleton 2 Risk and Retur n CAPM answer s two impor tant questions H ow to measur e r isk? H ow to quantify the r elationship between r etur n and r isk? CAPM has 3 impor tant applications: Valuation & Secur ity selection Per for mance M easur ement CAPM is based on moder n por tfolio theor y (M PT) . Ever yone holds a combination of the M ar ket Por tfolio & the r iskless asset. Risk is the covar iance of a r isky asset with the mar ket por tfolio Expected r etur n is linear with the covar iance. RSM 330 - Week 8 Stapleton 3 Market Portfolio will be used in the CAPM Everyone holds the mar ket por tfolio and the riskless asset. I t follows directly from the separ ation pr inciple . Riskless borrowing and lending are offset in the aggregate portfolio. S E R f Tangency por tfolio = M ar ket Por tfolio CA L Optimal por tfolios of individual investor s 4 RSM 330 - Week 8 Stapleton Security Market Line (SML) Asset 1 Market Portfolio Asset 2 5 RSM 330 - Week 8 Stapleton Key Points about CAPM : The r isk of a secur ity is its covar iance with the mar ket por tfolio. 6 RSM 330 - Week 8 Stapleton ) ( ) , ( M M i i r V ar r r C ov = The CAPM equation is: ( 29 f M i f i r r E r r E- =- ) ( ) ( Compensation for r isk = amount of r isk ( i ) x mar ket 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 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 investor s expect the stock to sell for at the end of the year ? Applications of CAPM: A Past Exam Question RSM 330 - Week 8 Stapleton 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 5 ....
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This note was uploaded on 07/16/2011 for the course COMMERCE 330 taught by Professor Stapleton during the Fall '10 term at University of Toronto- Toronto.

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Class Note 7_S2010 - RSM 330 - I nvestments Class 8 July...

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