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Topic 7 - BMGT 343 Investments Prof Anna Obizhaeva Office...

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1 Equities © Anna A. Obizhaeva BMGT 343: Investments Prof. Anna Obizhaeva Office: VMH 4428 Phone: (301) 405-7934 Email: [email protected] Section 0101 T Th 9:30-10:45 am in VMH 1336 Section 0201 T Th 11:00-12:15 pm in VMH 1336 Section 0301 T Th 12:30-1:45 pm in VMH 1336 Office Hours : Thu 3:00-4:00 pm or by appointment Equities © Anna A. Obizhaeva Equities Topic 7: The Capital Asset Pricing Model (CAPM)
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2 Equities © Anna A. Obizhaeva What We Learned So Far In Topic 6 (Portfolio Theory) we studied how investors choose an optimal portfolio. Efficient portfolios are derived through a tradeoff between risk and expected return. 1. Diversify to eliminate non-systematic risk. 2. Hold only the risk-free asset and the tangent portfolio . Crucial inputs were expected return and covariance matrix of individual stock returns. Portfolio theory analyzes investors’ asset demand given asset returns ! Equities © Anna A. Obizhaeva Our Goal In Topic 7 (The CAPM), we study how investors’ asset demand determines the relation between assets’ risk and return in a market equilibrium : - How are expected returns E(R) determined? - How are they related to risk ?
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3 Equities © Anna A. Obizhaeva Outline for Topic 7 - The CAPM. - CML and SML. - Uses of the CAPM. Equities © Anna A. Obizhaeva 1. The CAPM The CAPM is a theoretical model which provides insights on assets’ expected returns and how the are related to assets’ risk . The CAPM is considered the backbone of modern price theory for financial markets. It highlights important implications for various topics in financial economics. The CAPM was developed by Jack Treynor (1961) and William Sharpe (1964) building on the earlier work of Harry Markowitz on portfolio theory.
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4 Equities © Anna A. Obizhaeva William Sharpe Equities © Anna A. Obizhaeva Terminology Assume there are N risky assets (stocks) and a riskless asset (T-bill). The excess return of asset n is the asset’s return minus the return on the riskless asset, The expected excess return of asset n is the asset’s expected return minus the return on the riskless asset, f n R R ( ) f n R R E
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5 Equities © Anna A. Obizhaeva Market Portfolio Market portfolio is the portfolio of all risky assets traded in the market. The market value of the market portfolio is the total value of all risky securities. The weights of securities in this portfolio are, effectively, related to their market capitalization. Equities © Anna A. Obizhaeva Market Risk Premium We denote by the return on the market portfolio . The market risk premium is the expected excess return of the market portfolio, ( ) f M R R E M R
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6 Equities © Anna A. Obizhaeva The CAPM Assumptions The CAPM is based on the following simplifying assumptions : 1. There are N risky assets and a riskless asset. 2. Short sales are costless.
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