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Money Markets and Finance Lecture 8 Diversification – The Capital Asset Pricing Model (CAPM) and the Required Rate of Return for Risk 1. Lecture Overview In this lecture, we will use the material discussed last week to derive a model we can employ to calculate the required rate of return on a risky investment. The model we will develop is called the Capital Asset Pricing Model (“CAPM”), and is commonly used the in capital budgeting and valuation exercises we have discussed in earlier lectures. 1. Lecture Overview The primary use of the CAPM is in determining the appropriate discount rate to use in computing net present values (NPVs). Given this, after defining the CAPM, we will revisit the capital budgeting / valuation problems we considered in Lecture 5 and see how the CAPM can be used to take account of risk and uncertainty by developing a risk-adjusted discount rate. In other words, instead of having to be given discount rates for use in valuations, we will learn how to calculate them in this lecture. 2. Deriving the CAPM We know from Lecture 7 that investors want to maximize expected returns and minimize variance and will therefore hold diversified portfolios. These portfolios will be efficient in the sense that they maximize expected return for a given level of standard deviation. We also recall from Lecture 6 that a risk averse investor has to be paid to take on risk, that is, a risk averse investor will demand a risk premium for every unit of risk they take on. 2. Deriving the CAPM In earlier lectures, we have learnt a number of important things that are central to an intuitive derivation of the CAPM. We will now review each of these in turn and, subsequently, extend upon them: 1. Investors Prefer High Returns : We know that investors prefer more wealth to less. Therefore, other things being equal, investors will invest in assets that promise high returns. 2. Deriving the CAPM 2. Individuals are Risk Averse: Since individuals are risk averse and prefer high returns, they may forego some expected return in order to reduce risk. Moreover, because individuals are risk averse, they will demand to be paid to take on risk. That is, for every unit of risk that they take on, they will demand to be paid a risk premium. Hence our starting point for the required return on a risky asset is: Required Return = Risk-Free Rate + No. Units Risk [Risk Premium Per Unit of Risk]
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2. Deriving the CAPM 3. Investors Diversify in Order to Reduce Risk: You will recall that we established in Unit 5 that the process of diversification allows an investor to reduce the risk of his/her portfolio without sacrificing any expected return. Since investors are risk averse, they will seek to do this. Indeed, the traditional CAPM assumes that they will continue to do this until they are fully diversified, that is, until they have spread their wealth across all assets in the economy.
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