Lecture 4 - Lecture 4 The Capital Asset Pricing Model...

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Lecture 4 The Capital Asset Pricing Model (CAPM)
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Why Asset Pricing Models? Asset pricing models are often written as theories about the expected returns on different assets They can lead to superior estimates of expected returns for portfolio optimization: o We replace the historical averages with expected returns implied by the model o We otherwise estimate expected returns but use a model as a check Asset pricing models can provide a benchmark for performance evaluation: o Look at difference between realized returns and the expected return implied by the model o Look at the difference between realized returns and the return of another portfolio that the model regards as similar
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Financial Market Equilibrium Financial market equilibrium is a relation between the prices of different assets that, if disrupted, would naturally be restored by market forces. Equilibrium asset pricing models share certain features: o absence of arbitrage o expected returns are related to risk o risk is defined by covariance o “market forces” are rational investors o supply = demand, or “market clearing” If one portfolio of risky assets is preferred to another portfolio of risky assets by all investors, can the markets be in equilibrium? In equilibrium should more volatile assets always require a higher expected rate of return? If one portfolio of risky assets is preferred to the market portfolio of risky assets by all investors, can the markets be in equilibrium?
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The Capital Asset Pricing Model (CAPM) Suppose we are all Markowitz investors: o estimate assets’ means, variances, covariances o calculate the efficient frontier of risky assets o find the portfolio that maximizes the Sharpe ratio o invest in some combination of this risky portfolio and the riskless asset
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This note was uploaded on 02/06/2012 for the course MGMT 411 taught by Professor Clarke during the Spring '09 term at Purdue University-West Lafayette.

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Lecture 4 - Lecture 4 The Capital Asset Pricing Model...

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