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Unformatted text preview: Lecture 8: Capital Asset Pricing Model RSM 332 Capital Market Theory Rotman School of Management University of Toronto Mike Simutin November 2/3, 2011 Capital Asset Pricing Model RSM 332, 1/25 Why Is This Important? I Capital Asset Pricing Model (CAPM) is THE workhorse model in Finance I CAPM is very widely used both by academics and practitioners I CAPM is a very common way to measure performance of investment strategies I It also allows us to identify undervalued securities I CAPM gives us a way to measure required return on a project (e.g., new factory) and decide whether or not to go ahead with it I It is a way to obtain the discount rate necessary to calculate the present value of a firms future cash ows I CAPM allows us to measure risk and determine its market price Capital Asset Pricing Model RSM 332, 2/25 CAPM Assumptions I Investors are risk averse and maximize expected utility that depends only on mean and variance of returns I Assets returns are jointly normally distributed I Investors cannot inuence prices (they are price-takers) I Investors have identical expectations about asset returns I Investors plan for one identical holding period I Investors can borrow or lend an unlimited amount at the risk-free rate I There are no market imperfections (e.g., taxes, transaction costs, short-selling restrictions, etc.) I All assets are infinitely divisible Capital Asset Pricing Model RSM 332, 3/25 Towards the CAPM I MPT allows us to determine how an individual investor should allocate his or her wealth optimally I CAPM allows us to aggregate the actions of all investors to determine expected returns of any security I Several insights led Sharpe (along with Treynor and Lintner) to derive the CAPM: Expected Return, Percent 1 2 3 4 5 6 7 8 Standard Deviation, Percent 5 10 15 20 25 30 35 40 45 50 55 60 65 MVP Individual securities Ef icient Frontier RF Capital M arket Line M Portfolio M has the highest attainable Sharpe ratio All investors hold Portfolio M M must contain all risky assets In equilibrium, excess demand for any asset must be zero After some (quite simple) mathematical manipulations, we can derive the CAPM Capital Asset Pricing Model RSM 332, 4/25 Capital Asset Pricing Model Define the beta of any security i as i Cov ( R i , R M ) Var ( R M ) = iM 2 M = iM i M 2 M = iM i M CAPM states that the expected return on this security is E ( R i ) = R f + i [ E ( R M ) R f ] Expected return on security i = Risk-free rate + Beta of security i Market risk premium Capital Asset Pricing Model RSM 332, 5/25 CAPM: Simple Example You collect the following data: I Historical market risk premium is 6.5% per year I Expected return on the T-Bills is 1% per year I According to finance.google.com, Apples beta is 1.28 What is the expected annual return on Apples stock?What is the expected annual return on Apples stock?...
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This note was uploaded on 12/20/2011 for the course RSM 332 taught by Professor Raymondkan during the Fall '08 term at University of Toronto- Toronto.
- Fall '08