The Capital Asset Pricing Model

The Capital Asset Pricing Model - The Capital Asset Pricing...

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8-1 The Capital Asset Pricing Model A Conceptual Development of the CAPM The existence of a risk-free asset resulted in deriving a capital market line (CML) that became the relevant frontier However, CML cannot be used to measure the expected return on an individual asset For individual asset (or any portfolio), the relevant risk measure is the asset’s covariance with the market portfolio That is, for an individual asset i, the
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8-2 The Capital Asset Pricing Model Applying the CML using this relevant risk measure Let βi=(σi riM) / σM be the asset beta measuring the relative risk with the market, the systematic risk The CAPM indicates what should be the expected or required rates of return on risky assets ] E(R [ r RFR ) E(R M iM i M i RFR σ σ - + = ) ] ) [ RFR i - + = M i E(R RFR ) E(R β
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8-3 The Capital Asset Pricing Model The Security Market Line (SML) The SML is a graphical form of the CAPM Exhibit 8.5 shows the relationship between the expected or required rate of return and the systematic risk on a risky asset The expected rate of return of a risk asset is determined by the RFR plus a risk premium
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