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Unformatted text preview: CAPM 1 CAPM Introduction to CAPM The CAPM has a variety of uses: It provides a theoretical justification for the widespread practice of passive investing known as indexing . Indexing means holding a portfolio similar to a broad market index such as the S&amp;P 500. * Individual investors can just buy an index fund . CAPM 2 CAPM can provide estimates of expected rates of return on individual investments Estimates based on the mean of historic time series are known to be inaccurate * the problem is lack of enough data So alternative estimates are useful CAPM can establish fair rates of return on invested capital in regulated firms or in firms working on a costplus basis what should the plus be? CAPM 3 CAPM starts with the question, what would be the risk premiums on securites if the following assumptions were true? The market prices are in equilibrium. In particular, for each asset, supply equals demand. Everyone has the same forecasts of expected returns and risks. CAPM 4 All investors chose portfolios optimally according to the priniciples of efficient diversification. This implies that everyone holds the tangency portfolio of risky assets as well as the riskfree asset. * only the mix of the tangency portfolio and the riskfree varies between investors CAPM 5 The market rewards people for assuming unavoidable risk, but there is no reward for needless risks due to inefficient portfolio selection. Therefore, the riskpremium on a single security is not due to its stand alone risk, but rather to its contribution to the risk of the tangency portfolio. * The various components of risk will be discussed later. Return can either refer to oneperiod net returns or oneperiod log returns. CAPM 6 Suppose there are three assets with a total market value of $100 billion. Stock A: $60 billion Stock B: $30 billion riskfree: $10 billion CAPM 7 The market portfolio of Stock A to Stock B is 2:1. CAPM says that under equilibrium, all investors will hold Stock A to Stock B in a 2:1 ratio. Therefore, the tangency portfolio puts weight 2/3 on Stock A and 1/3 on Stock B all investors will have twothirds of their allocation to risky assets in Stock A and onethird in Stock B. CAPM 8 Suppose there was too little of Stock A and too much of Stock B for everyone to have a 2:1 allocation. For example, assume: one million shares of each stock and the price per share was $60 for Stock A and $40 for Stock B. Then the market portfolio must hold Stock A to Stock B in a 3:2 ratio, not 2:1. Not everyone could hold the tangency portfolio. CAPM 9 Prices would be in disequilibrium and would change....
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This note was uploaded on 04/06/2008 for the course ORIE 473 taught by Professor Anderson during the Spring '07 term at Cornell University (Engineering School).
 Spring '07
 ANDERSON

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