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Capital Asset Pricing Model

# Capital Asset Pricing Model - such an index The advantage...

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Capital Asset Pricing Model Equation (11) says that the expected return on any asset is equal to the risk-free return plus the cost of risk . This is the main result of the Capital Asset Pricing Model. According to the CAPM, the two most important characteristics of an asset are its risk and return. Beta provides a measure of the relative risk of an asset. The different returns on an asset are entirely explained by the differences in their relative risks or betas. The higher the beta, the higher the expected return on that asset. Mutual Funds: Active Management or an Index Fund? The CAPM can be used to compare different investments with respect to the risk and return, for example, mutual funds. Studies have found that funds with high betas generally have high returns to compensate people for bearing greater risk. A stock index measures the average returns on a given day of a certain group of stocks, e.g. Dow-Jones Index, S&P 500. An index fund is a mutual fund that holds the stocks that make up

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Unformatted text preview: such an index. The advantage is that you get the average performance of the stocks in the index with low management fees. The beta of an index fund is approximately 1 since it holds a broad base of risky assets. It holds nearly all the stocks in the market as a whole. Plot the expected return and beta of a S&P index fund and draw a line connecting it to R f . You can get any combination of return and risk along this line by deciding how much to invest in the risk-free asset and the index fund. If you were to plot the betas and returns of actively managed mutual funds on this graph, you would f ind that the vast majority of risk/return combinations offered by mutual funds are below the line. Here is a short article by Nobel Prize winning economist William Sharpe on active versus passive investing . Dow Jones Industrial Average Over Time...
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Capital Asset Pricing Model - such an index The advantage...

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