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Topic Six - CAPM - Topic 6 Capital Asset Pricing Model...

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Topic 6 Capital Asset Pricing Model Craig Mellare University of Sydney
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Lecture Outline Derive an explicit model of the required return on any asset by developing 4 basic building blocks for the model put together the building blocks to form the model Discuss tests of the validity of the model Demonstrate how to estimate the parameters of the model
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Building Block 1 Types of Risk Faced by Investors Total Risk Market Risk (systematic risk, non-diversifiable risk) price variability of a security associated with systematic market movements which cannot be diversified away eg. price movement brought on by an unexpected economic recession
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Building Block 1 Types of Risk Faced by Investors Unsystematic Risk (or unique risk, diversifiable risk) price variability of a security which is unique to a security, and can be diversified away if the security is held in a portfolio eg. price movement associated with a poor earnings announcement
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Building Block 1 Types of Risk Faced by Investors Since: 1. Combining stocks in portfolios eliminates unsystematic risk 2. Investors hold stocks in portfolios (assumption) Investors only face systematic risk
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Building Block 2 Measuring Market Risk - β Market model E(r i ) = a + β (E(r m )] β measures the responsiveness of a securities returns to market returns Interpretation of β β =1 [market] β <1 [risk of security is lower than average market risk] β >1 [risk of security is higher than average market risk]
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Building Block 3 Do the mean and standard deviation of returns adequately describe asset risk and return? 1. Stock returns are normally distributed 2. A normal distribution is completely described by its mean and standard deviation Return/Risk is completely described by mean and standard deviation of returns Hence: Investors need only be concerned with the mean and standard deviation of returns on a security in deciding on their investment
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Distribution of Daily Stock Returns for AGL in 1997 AGL 0 2 4 6 8 10 12 14 16 18 -15 -14 -13 -12 -11 -10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Daily Return Frequency
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Distribution of Daily Stock Returns for FOA in 1997 FOA 0 2 4 6 8 10 12 14 16 18 -15 -14 -13 -12 -11 -10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Daily Return Frequency
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Distribution of Daily Returns on All Ords - 1980 to 1997 0 100 200 300 400 500 600 700 -10.00% -8.75% -7.50% -6.25% -5.00% -3.75% -2.50% -1.25% 0.00% 1.25% 2.50% 3.75% 5.00% 6.25% 7.50% 8.75% 10.00% Daily Return Frequency
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Distribution of Monthly Returns on All Ords - 1980 to 1997 0 5 10 15 20 25 -15.00% -13.00% -11.00% -9.00% -7.00% -5.00% -3.00% -1.00% 1.00% 3.00% 5.00% 7.00% 9.00% 11.00% 13.00% 15.00% Monthly Return Frequency
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Building Block 4 Rational Portfolio Choice
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