Topic 3 - Topic3:AssetPricingModels...

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Topic 3: Asset Pricing Models Capital Asset Pricing Model Market Portfolio Capital Market Line vs. Security  Market Line Arbitrage Pricing Theory
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Capital Asset Pricing Model Focus on the equilibrium relationship  between the risk and expected return on  risky assets Builds on Markowitz portfolio theory Each investor is assumed to diversify  his or her portfolio according to the  Markowitz model
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CAPM Assumptions All investors: Use the same  information to  generate an efficient  frontier  Have the same one- period time horizon Can borrow or lend  money at the risk- free rate of return No transaction  costs, no personal  income taxes, no  inflation No single investor  can affect the price  of a stock Capital markets are  in equilibrium  
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Borrowing and Lending Possibilities Risk free assets  Certain-to-be-earned expected return and  a variance of return of zero No correlation with risky assets Usually proxied by a Treasury security Amount to be received at maturity is free of  default risk, known with certainty Adding a risk-free asset extends and  changes the efficient frontier
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Risk-Free Lending Riskless assets can  be combined with  any portfolio in the  efficient set AB Z implies lending Set of portfolios on  line RF to T  dominates all  portfolios below it B A T E(R) RF L Z X Risk
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Impact of Risk-Free Lending If w RF  placed in a risk-free asset Expected portfolio return Risk of the portfolio Expected return and risk of the portfolio  with lending is a weighted average
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Borrowing Possibilities Investor no longer restricted to own  wealth Interest paid on borrowed money Higher returns sought to cover expense Assume borrowing at RF Risk will increase as the amount of  borrowing increases Financial leverage
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This note was uploaded on 10/04/2011 for the course FINANCE FINANCE taught by Professor Don'tknow during the Spring '09 term at American Internation College.

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Topic 3 - Topic3:AssetPricingModels...

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