Lecture_05

Lecture_05 - The Capital Asset Pricing Model(CAPM Professor...

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Fall 2010 Investment Management, FINE 1 Professor Ruslan Goyenko The Capital Asset Pricing Model (CAPM)
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Fall 2010 Investment Management, FINE 2 Introduction to CAPM Ø How do we identify the tangency portfolio? Ø Is it different for different investors? Must be the same if investors agree on the measure of an asset’s relevant risk. Ø CAPM provides assumptions under which all investors do agree on the benchmark (tangency) portfolio—this is referred to as the “market” portfolio, M . Ø An asset’s relevant risk is the portion of its risk which cannot be diversified away by including it as an element of M .
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Fall 2010 Investment Management, FINE 3 CAPM Assumptions Ø Mean-variance criterion: Investors care about risk and return only in terms of mean and variance. Ø Homogeneous expectations: Same information about the distribution of an asset’s returns, and process the information in the same manner. Ø Competition: Security markets are competitive and investors are price takers. Ø Investors can borrow or lend freely at the risk-free rate. Ø Single-period investment horizon. Ø Transactions costs: No taxes and transactions costs.
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Fall 2010 Investment Management, FINE 4 CAPM Assumptions – Cont’d Ø These assumptions are clearly not satisfied in reality: Any model is an approximation of reality. Ø Results based on CAPM must necessarily be viewed as approximations.
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Fall 2010 Investment Management, FINE 5 Capital Market Line (CML) Ø Same efficient frontier of for all investors—Investors differ only in the proportion of their wealth invested in the risk-free asset versus M . Ø CML describes the relationship between risk and return only for efficient portfolios Ø If an investor were to hold a portfolio not lying on the CML, s/he would be bearing unnecessary excess risk: no optimizing Investments student would hold such a portfolio ( 29 ( 29 p M f M f p r r E r r E σ - + =
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Fall 2010 Investment Management, FINE 6 Composition of M: Equilibrium Ø Under financial market equilibrium, the supply and demand of risky assets must equal at the prevailing prices. Ø Thus, what investors want to hold, M, must equal what they actually do hold: Market portfolio contains all risky assets and the proportion of each asset is its market value as a percentage of total market value. The weight on asset i in the market portfolio is given by assets risky all of ue market val Total asset of ue market val Total i w i =
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Fall 2010 Investment Management, FINE 7 Characterizing the Market Portfolio Ø Since every risky asset is in
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This note was uploaded on 02/28/2012 for the course FINE 441 taught by Professor Ruslangoyenko during the Spring '08 term at McGill.

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Lecture_05 - The Capital Asset Pricing Model(CAPM Professor...

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