CAPM_Updated - Chapter 7 Capital asset pricing model 1...

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Chapter 7 Capital asset pricing model 1
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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?
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Investors are risk averse Investors consider expected returns and expected standard deviations on the returns Min risk ( standard deviation of returns) given return and Max returns given risk 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 3
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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
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5 Daily return distributions of Rio Tinto, 2007 2010 0 5 10 15 20 25 30 35 -0.06 -0.04 -0.02 -0.00 0.02 0.04 0.06 2010 0 5 10 15 20 25 30 35 40 -0.20 -0.15 -0.10 -0.05 0.00 0.05 0.10 2009 0 10 20 30 40 50 60 70 80 -0.4 -0.3 -0.2 -0.1 0.0 0.1 2008 0 5 10 15 20 25 30 35 -0.05 -0.00 0.05 0.10 2007
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1.2 Possible portfolios two shares feasible portfolios contains all combinations of stocks and show resulting risk and return combinations We will examine several feasible portfolios using Rio Tinto and Orica Ltd shares Example Daily risk-return characteristics for RIO and ORI, 2007 _______________________________________________ RIO ORI Mean 0.002596 0.001311 Standard deviation 0.023250 0.021835 Covariance with RIO 0.000166 6 = 0.33
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Example Feasible portfolios containing RIO and ORI, 2007 Portfolio number Proportion in portfolio Standard deviation Mean return (%) RIO ORI 1 1 0 2.3250 0.2596 2 0.95 0.05 2.2468 0.2532 3 0.9 0.1 2.1737 0.2468 4 0.85 0.15 2.1062 0.2403 5 0.8 0.2 2.0449 0.2339 6 0.75 0.25 1.9903 0.2275 7 0.7 0.3 1.9429 0.2211 8 0.65 0.35 1.9035 0.2146 9 0.6 0.4 1.8723 0.2082 10 0.55 0.45 1.8500 0.2018 11 0.5 0.5 1.8367 0.1954 12 0.45 0.55 1.8326 0.1889 13 0.4 0.6 1.8380 0.1825 14 0.35 0.65 1.8525 0.1761 15 0.3 0.7 1.8761 0.1697 16 0.25 0.75 1.9084 0.1632 17 0.2 0.8 1.9490 0.1568 18 0.15 0.85 1.9974 0.1504 19 0.1 0.9 2.0530 0.1440 20 0.05 0.95 2.1152 0.1375 21 0 1 2.1835 0.1311 7 2. Possible portfolios two shares
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Example Feasible portfolios containing RIO and ORI, 2007 FIGURE 7.3 This chart shows the risk/return characteristics for 21 different feasible portfolios of RIO & ORI 100% in ORI 100% in RIO All portfolios to the left of the dotted line have less risk than either RIO or ORI individually 0.1300 0.1500 0.1700 0.1900 0.2100 0.2300 0.2500 0.2700 1.8000 1.9000 2.0000 2.1000 2.2000 2.3000 2.4000 Risk - Return combinations 8 2. Possible portfolios two shares Min Variance combination
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1.3 Possible portfolios – multiple stocks The set of feasible portfolios for a large number of stocks is enveloped by a parabola, referred to as the opportunity set of risky portfolios Each point within the opportunity set represents a possible level of risk and return that an investor can achieve 9
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FIGURE 7.4 depicts the predicted plot of the set of feasible portfolios constructed from all stocks listed on the ASX Expected return (%) Standard deviation of returns (%) 10 3. Possible portfolios – multiple stocks
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1.4 Choosing the optimum portfolio
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This note was uploaded on 03/09/2012 for the course FINC corporate taught by Professor Kim during the Three '11 term at University of Sydney.

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CAPM_Updated - Chapter 7 Capital asset pricing model 1...

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