Chapter 7
Capital asset pricing model
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Table of Contents
1. Rational portfolio Choice
1.1 The distribution of security returns
1.2 Possible portfolios
‐
two shares
1.3 Possible portfolios – multiple stocks
1.4 Choosing the optimum portfolio
1.5 Optimum portfolios – multiple shares plus a risk
‐
free
asset
2. The capital asset pricing model (CAPM)
2.1 Another way of thinking about the CAPM
2.2 The security market line
3. Estimation of beta
4. Does the CAPM work?

•
Investors consider expected returns and expected standard
deviations on the returns
–
Min
sd
given return and
–
max returns given
sd
•
This assumption is only valid if stock returns follow a
normal distribution
–
But are returns on assets normally distributed?
1.
Rational portfolio Choice
1.1 The distribution of security returns
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•
This bar chart plots the distribution of
daily returns
on Rio Tinto (RIO)
for 2007
•
The solid line represents a theoretical normal distribution
•
Hence, the daily return on RIO
roughly
approximates a normal
distribution
FIGURE 7.1
4
1. The distribution of security returns