L7_post_1 - Ch7. Capital Asset Pricing Model and Arbitrage...

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1 Investment Analysis: Prof. Peng 1 Ch7. Capital Asset Pricing Model and Arbitrage Pricing Theory Part I. CAPM model: CAL and SML Part II. Index models Part III. Arbitrage and Multi-factor models Investment Analysis: Prof. Peng 2 Eff. Frontier with Riskfree Asset E[r] O F O O efficient frontier with risk free asset optimal risky portfolio
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2 Investment Analysis: Prof. Peng 3 CAPM William E. Sharpe (1964) studies the equilibrium effect of individual investor’s portfolio decision What happens if all investors follow the portfolio strategy we discussed before Which optimal risky portfolio should an investor hold? What kind of risk will be rewarded with higher expected return? Capital Asset Pricing Model Precise prediction of the relation of risk and expected return An equilibrium model underlying modern finance theory Investment Analysis: Prof. Peng 4 CAPM assumptions Assumptions about investors cannot affect prices by their individual trades. plan for one identical holding period. form portfolios from stocks, bonds and a risk free security. are rational mean-variance optimizers attempt to construct efficient frontier portfolios have homogeneous expectations agree with each other on expected return, std. dev. and correlations Assumption about market frictionless: no taxes, and transaction costs
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3 Investment Analysis: Prof. Peng 5 CAPM Resulting Equilibrium Outcome All investors will hold the market portfolio (M) market portfolio contains all risky securities the proportion of each security is its market value as a percentage of total market value M is the optimal risky portfolio (tangency portfolio) Risk aversion only affects relative weights between portfolio M and riskfree security Risk premium on M proportional to and the average risk aversion of investor Risk premium on an individual security is a function of its covariance with the market 2 M Investment Analysis: Prof. Peng 6 Risk premium of market portfolio M E(r P ) P CML E(r f ) M E[r M ] p r r E r r E f p f M portfolio efficient of premium Risk : ] [ premium risk Market : ] [ : ] [ M f M r r E market price of risk (market risk premium per unit of market risk) The capital market line (CML): –the relationship between expected return and std for efficient portfolios
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4 Investment Analysis: Prof. Peng 7 The risk premium on individual securities The risk premium on individual securities or arbitrary portfolios What’s beta measures the extend security i ’s return respond to market’s return. is a function of the amount of market risk
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This note was uploaded on 08/26/2011 for the course ECO 220 taught by Professor Huang during the Spring '08 term at CUNY Hunter.

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L7_post_1 - Ch7. Capital Asset Pricing Model and Arbitrage...

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