Factors affecting
Beta
(1) time
period you choose
(2) Type of returns
used - daily,
weekly, annual, etc
(3) what is used as
proxy for market pf
returns (eg. S&P
500)
Security Market Line (SML)
directly translates beta into an
est required rate of return.
Slope =
Mkt premium risk = reward-to-risk ratio=
R
m
−
R
f
Y- intercept:
Risk-free rate, assumes
σ
=
0
.
*Same mkt, same SML
Expected >
Required
Above
SML
Underpriced stock/asset
(shd buy)
Expected <
Required
Below
SML
Overpriced stock/asset
(shd sell)
Expected =
Required
On SML
Fairly priced stock/asset
Capital Asset Pricing Model
for both physical and financial
assets.
Required rate of return,
R
M
= Market rate. B (Rm – Rf) = req risk premium of sec
Ri – Rf = expected risk premium of sec.
R
M
−
R
f
=
¿
risk premium/reward to risk ratio/slope
R
f
=
¿
time value of money/risk free rate
Factors affecting CAPM
1.
Pure time value of money – measured by the risk-free
rate (Rf)
2.
Reward (risk premium) for bearing systematic risk
determined by the:
(i) Systematic risk measure (captured by Beta)
(ii) Market risk premium
Project Valuation
After calculating the required rate of return (which is i/y), calc
for pv to see how much you shouldn’t pay more than for each
time period, then add tgt.
Acc to CAPM, security’s expected return is positively and
linearly related to security’s beta.
CAPM defines the relationship between risk and required
rate of return.
Extremely large no. of bond issues, but generally low daily
volume in single issues
CAPM defines the relationship between risk and required
rate of return
r
ˆ
Mean
Deviation
Standard
Return
of
Rate
Expected
Deviation
Standard
CV
i
RF
i
RP
r
r
i
RF
M
RF
r
r
r

Many analysts use S&P500’s returns as a ‘proxy’ for mkt
portfolio returns (to be used in the CAPM). The returns of the
company of interest are then regressed on S&P’s returns to
find the company’s beta.
Markowitz Portfolio Theory
portfolio return against
portfolio sd. Efficient portfolio is one that: (1) provides
greatest expected return for a given lvll of s.d. (risk) or (2)
lowest risk for a given expected return. Rational investor shdnt
choose any other portfolio.
Mkt portfolio is the portfolio at tangent line of the risk free
asset with the efficient frontier of all risky assets available.
Capital Mkt Lin
(CML
) is the
tangent line
drawn from the
point of the risk-
free asset to the
feasible region
for risky assets.
Tangency point
represents the
market portfolio; hence all rational investors should hold their
risky assets in the same proportions as their weights in the
market portfolio

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- Winter '14
- Capital Asset Pricing Model, Investing