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Unformatted text preview: Capital Asset Pricing Model BKM: Chapter 7 Review: Optimal Portfolios Given current expected returns, standard deviations, and correlations: Choose risky portfolio to maximize Sharpe ratio. Tailor the risk by investing (long or short) in the risk free asset. This is the right approach whether or not markets are efficient. Review: Beating the Market Beating the market means more than earning a higher average return You could do this by simply investing in smallcap stocks. Beating the market means developing a portfolio with a higher Sharpe ratio. Review: Beating the market To beat the market: you should continually be searching for stocks such that (E[r]r f )/ (E[r M ]r f ) > tilt towards these (E[r]r f )/ (E[r M ]r f ) < tilt away from these By tilting the market portfolio as above, you increase the Sharpe ratio of the portfolio. New Topic: Asset Pricing If markets are efficient Excess returns follow a constant + white noise process We cant predict our best guess is zero k i is the risk premium for company i . Merket efficiency: prices equate risk premiums with fair value. Why do fair risk premiums differ across stocks? i i f i i k r Get + = 1 Price Models of risk premium Capital Asset Pricing Model Requires many assumptions Model is very specific Arbitrage Pricing Model Requires light assumptions Model is more general Accounting Ratios Can be difficult to interpret Relies more on gut instinct Pumpkin Crusher Pays $.50 Pays $1.00 Pays $1.00 Pumpkin Crusher chooses one and only one color to crush and steal the money. He crushes White with 50% probability, and Gold with 50% probability. Green never gets crushed. You need $2 to feed your family. You currently have 2 green and 1 white pumpkins plus 45 cents. Why is Gold so Attractive? Gold is attractive because it acts like a hedging instrument. The pay off high right when white gets crushed. Note that the covariance of the payoff between gold and your original portfolio is negative ....
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This note was uploaded on 03/01/2012 for the course BUS M 410 taught by Professor Brianboyer during the Fall '10 term at BYU.
 Fall '10
 BrianBoyer
 Pricing, Capital Asset Pricing Model, Investing

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