Ch7_Kim_BKM_INV_8th - Bodie Kane Marcus Essentials of...

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Essentials of Investments Bodie • Kane • Marcus Chapter 7 Capital Asset Pricing and Arbitrage Pricing Theory
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Essentials of Investments Bodie • Kane • Marcus Capital Asset Pricing Model (CAPM) CAPM: A model that relates the required rate of return for a security to its risk measured by beta. CAPM predicts the relationship between the risk and equilibrium expected returns on risky assets. CAPM is derived using principles of diversification with simplified assumptions. CAPM is first proposed by Sharpe (1964), and Markowitz, Sharpe, Lintner and Mossin are researchers credited with its development.
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Essentials of Investments Bodie • Kane • Marcus CAPM: Assumptions Individual investors cannot affect prices by their individual trades. There are many investors, each with an endowment of wealth that is small compared with total endowment of all investors. Single-period investment horizon All investors plan for one identical holding period . Investors form portfolios from a universe of publicly traded financial assets, and have access to unlimited risk-free borrowing or lending. Investors pay neither taxes on returns nor transaction costs on trades in securities.
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Essentials of Investments Bodie • Kane • Marcus CAPM: Assumptions (continued) All investors attempt to construct efficient frontier portfolio. Investors are rational mean-variance optimizers Information is costless and available to all investors Homogeneous expectations All investors analyze securities in the same way and share same economic view of the world. They all end with identical estimates of the probability distribution of future cash flows from investing in the available securities. All investors use the same expected return, standard deviations, and correlations to generate efficient frontier and the unique optimal risky portfolio.
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Essentials of Investments Bodie • Kane • Marcus Resulting Equilibrium Conditions All investors will choose to hold the same optimal risky portfolio – Market portfolio. Market portfolio contains all securities in the market and the proportion of each security is its market value as the percentage of total market value. The market portfolio will be on the efficient frontier, and it will be the optimal risky portfolio. The CML, the line from risk-free rate through the market portfolio, is the best attainable CAL. All investors will hold the market portfolio as their optimal risky portfolio, differing only in the amount invested in it compared to investment in risk-free asset.
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Essentials of Investments Bodie • Kane • Marcus In equilibrium, the risk premium on the market portfolio, [ E(r M ) – r f ], must be just high enough to induce investors to hold the available supply of stocks. If the risk premium is too high compared to the
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This note was uploaded on 12/13/2011 for the course MANAGEMENT 103 taught by Professor Mr.singh during the Spring '11 term at Aristotle University of Thessaloniki.

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Ch7_Kim_BKM_INV_8th - Bodie Kane Marcus Essentials of...

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