CAPM DQ - Session 8: Capital Asset Pricing Model A. This...

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Unformatted text preview: Session 8: Capital Asset Pricing Model A. This ensures that all investors choose the same portfolio of risky assets (on the basis of reward to variability ratio or excess return per unit of risk) from the common opportunity set or efficient frontier. B. The capital market line is built upon the CAPM. It shows the risk-return combination of portfolios formed by combining the risk free asset and the market portfolio in different proportions. The market portfolio is a value-weighted portfolio of all risky assets publicly traded in the market. The capital allocation line shows the risk-return combination of portfolios formed by combining the risk free asset and any portfolio of risky assets in different proportions. The portfolio of risky assets may or may not contain all the risky assets publicly traded in the market. The capital allocation line is called the capital market line if and only if the portfolio of risky asset is the market portfolio. C. The security market line shows the level of return required by investors to invest in a risky asset or portfolio with a given level of beta risk. It concerns the pricing of risk that an individual security or portfolio contributes to the market portfolio. It may be used to test if a security is mispriced. On the other hand, the capital market line shows the relationship between the expected return and standard deviation of returns of portfolios formed by combining the risk free asset with the market portfolio (that every investor should hold). The CML concerns the pricing of risk of efficient portfolios. It may be used to evaluate funds performance and test if a fund has beaten the market. D. Composition of return: The expected return of a risky asset or portfolio is composed of a risk-free return and a risk premium. Pricing of systematic risk: The market price of systematic risk is given by the excess return of the market portfolio. The unit of risk is expressed in terms of beta. Relationship between expected return and beta: The expected return of an asset is directly related to its beta. Meaning of beta: Beta reflects the amount of risk that a risky asset contributes to the market portfolio. It also measures the degree of responsiveness of the excess return of a risky asset to the movement in excess return of the market portfolio. The larger the beta, the more risky the asset becomes. 1 Unsystematic risk: Unsystematic risk is not priced. In other words, investors are not rewarded for unsystematic risk or uncertainty in returns that are caused by firm specific event. F. No, because under CAPM, every investor is holding the market portfolio, which is a value-weighted portfolio of all publicly traded stocks and bonds. G. The absolute amount of risk contributed by ABC is: 2 = wABC [w1 cov(rABC , r1 ) + w2 cov(rABC , r2 ) + ... + wABCσ ABC + ... + wn cov(rABC , rn )] = wCBA cov(rCBA , rM ) where wi is the weight allocated to asset i, cov(ri, rj) is the covariance of returns between asset i and j, σ i2 is the standard deviation of returns of asset i. The relative amount of risk contributed by ABC is: cov(rABC , rM ) = wABC × 2 σM = wABC β ABC where β ABC is known as the asset beta for ABC. H. The CAPM may also be used to • conduct performance evaluation by comparing the Sharpe ratio of alternative investments, • measure the beta of individual assets, and • benchmark the price of risk for individual assets. For each unit of beta risk, investors should demand a risk premium of [E(RM) – rf] on top of the risk free rate of return. 2 3 ...
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