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FIN401-Chapter 7 (exam 2)

FIN401-Chapter 7 (exam 2) - Chapter 7 Chapter 7 Asset...

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Unformatted text preview: Chapter 7 Chapter 7 Asset Pricing Models Capital Asset Pricing Model (CAPM) Capital Asset Pricing Model (CAPM) ► Focus on the equilibrium relationship between the risk and the expected return on risky assets ► Builds on Markowitz portfolio theory Derived using principles of diversification with simplified assumptions CAPM Assumptions CAPM Assumptions Investors use the same information ► Investors have the same time horizon ► Investors can borrow and lend at the risk­free rate ► No transaction costs, personal income taxes or inflation ► No single investor can affect the price of a stock ► Investments are limited to traded financial assets ► Market Portfolio Market Portfolio ► Most important implication of CAPM ► All risky assets must be in portfolio, so it is completely diversified ► All securities included in proportion to their market value ► Proxied by the S & P 500 Security Market Line Security Market Line ► Under CAPM, all investors hold the market portfolio ► The Security Market Line (SML) depicts the linear relationship between an asset’s risk and its required rate of return ► A security’s contribution to the risk of the market portfolio is based on beta Beta Beta ► Beta is a measure of the systematic risk of a security that cannot be avoided through diversification ► The overall market beta is 1 » Riskier stocks (more volatile than the market) have Betas greater than 1 » Less risky stocks: Betas less than 1 CAPM CAPM ► Required rate of return ki = Risk free rate + Risk premium = RF + Bi [ E(Rm) – RF] ► The greater the systematic risk, the greater the required rate of return Security Market Line SML E(R) kM kRF 0 C 0.5 B 1.0 1.5 BetaM A 2.0 SML Relationships SML Relationships β = [COV(ri,rm)] / σm2 = Slope SML = E(rm) ­ rf = market risk premium Disequilibrium Example E(r) E(r SML 15% Rm=11% 13% rf=3% 1.0 1.25 ß Suppose a security with a β of 1.25 is offering an expected return of 15% According to the SML, k should be 13% Is the security underpriced or overpriced? Disequilibrium Example E(r) E(r SML 15% Rm=11% 13% rf=3% 1.0 1.25 ß Suppose a security with a β of _____ is offering an expected return of _____ According to the SML, k should be _____ __________: Its rate of return is ________ for its level of risk. ◊ The difference between the return required for the risk level as measured by the CAPM and the actual return is called the stock’s _______ denoted by _____. More on Alpha and Beta More on Alpha and Beta E(rM) βS rf = 14% = 1.5 = 5% Required return (k) = rf + βS [E(rM) – rf] = .05 + 1.5(.14­.05) = 18.5% If you believe the stock will actually provide a 17% return, is the stock overpriced or underpriced? What is the implied alpha? α = Overpriced (will plot below the SML) 17% ­ 18.5% = ­1.5% Estimating the SML Estimating the SML ► ______________ rate used to estimate RF ► Expected market return is ______________ → Estimated using________________________ Estimated using ► Estimating __________________________ is difficult Evaluating the CAPM Evaluating the CAPM ► Principles of the CAPM are valid → Investors should ________________. Investors should → Systematic risk is the ____________________. Systematic risk is the → A ___________________ can be suitable for a A wide range of investors. - Adjust for ____________________ differences Adjust for - _______________________ based on risk tolerance _______________________ ...
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