# Lecture7 - Chapter 9 20:30 Capital Asset Pricing Model In...

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Capital Asset Pricing Model 07/15/11 20:30 References Corporate Finance: An Introduction (Welch, 2009, Prentice Hall) Chapter 9 • In today’s lecture, we learn a formula which is used to determine the correct rate of return of a company’s stock • The key result is a simple formula, which many company managers use

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2 Some Example Portfolios 6-1B Probability State of World Stocks Portfolios A B C ½ A, ½ B ½ A, ½ C 1/4 Yellow 10% 8% -9% 9% 0.5% 1/4 Red 5% 4% -5% 4.5% 0% 1/4 Green -2% 0% 7% -1% 2.5% 1/4 Blue -3% -4% 15% -3.5% 6% E[r] 2.25% 2% 2% 2.25% 2.25% St.Dev.[r] 6.14% 5.16% 11.02% 5.61% 2.72% • The second portfolio, split evenly between A and C, is better than the first, split evenly between A and B --- same return, half the risk.
3 Individual vs. Portfolio Risk 8-1 • Look at the table again. C is clearly riskiest of three stocks. C is also the least desirable stock. A and B have at least as high return, and about half the risk • But, a portfolio combining A and C has half the risk of a portfolio combining A and B! C is a better addition to a portfolio than B, because it contributes more to reducing portfolio risk. This is because C is negatively correlated with A (i.e., moves in opposite direction), while B is positively correlated • Key point: when adding stock to portfolio, individual risk does not matter. Contribution to portfolio risk does. But how do we measure risk contribution? And what does this have to do with stock returns?

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4 CAPM, Logic 8-1 • You already knew: investments which are riskier have to offer
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## This document was uploaded on 11/04/2011 for the course FINANCE 0901 at Brown College.

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Lecture7 - Chapter 9 20:30 Capital Asset Pricing Model In...

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