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Unformatted text preview: Chapter 9: Capital Market Theory CHAPTER OVERVIEW Chapter 9 follows Chapters 7 and 8 because capital market theory builds on portfolio theory by examining how asset prices are determined in a world of Markowitz diversifiers. Chapter 9 also contains some important concepts relevant to a better understanding of such topics as systematic and nonsystematic risk and beta. The first part of Chapter 9 outlines the necessary assumptions to derive capital market theory and introduces the concept of equilibrium in the capital markets. Important related concepts are introduced and discussed, primarily the market portfolio. Both its importance and its composition are considered. Using the concepts developed to this point, the equilibrium risk--return tradeoff is analyzed in detail. The capital market line is developed and illustrated. This line applies to efficient portfolios, with the slope of the line showing the market price of risk for efficient portfolios. The equation is explained, and certain points about the line are emphasized. The security market line is developed next. The equation is developed, and beta as a measure of volatility is considered in some detail. The CAPM's expected return--beta relationship is analyzed, with each of the components of the required rate of return analyzed and explained. The process of identifying undervalued and overvalued securities using the SML follows this discussion. Problems in estimating the SML are described, and this leads into a detailed discussion of the accuracy of beta estimates and tests of the CAPM. The characteristic line is also explained. The chapter concludes with a complete discussion of Arbitrage Pricing Theory in terms of what beginners need to know. Although this concept probably has not advanced in terms of being widely used in the investments world as much as some have predicted, it is an important development that can be used for discussion purposes if the instructor so chooses. Factor models are explained as part of this discussion. A reasonably detailed discussion on understanding the APT is included. Consistent with the emphasis in this text, the use of APT in investment decisions is considered. Students should be able to see how the model could be applied in actual practice. 9-1 NOTE: The discussion of APT probably contains all that beginners need to know and can reasonably handle. CHAPTER OBJECTIVES 1. To develop the concept of asset pricing theory as a natural extension of portfolio theory. 2. To develop the concepts of the CML and SML, explain what they mean, and consider how they can be used. 3. To discuss related issues such as what beta measures and the problems with estimating beta, systematic and nonsystematic risk, problems in testing asset pricing models, and so forth....
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- Fall '11