CML

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Slide 1: 

1 THE CAPITAL ASSET PRICING MODEL Prepared By: VIKAS DALMIA

THE CAPM ASSUMPTIONS : 

2 THE CAPM ASSUMPTIONS NORMATIVE ASSUMPTIONS expected returns and standard deviation cover a one-period investor horizon nonsatiation risk averse investors assets are infinitely divisible risk free asset exists no taxes nor transaction costs

THE CAPM ASSUMPTIONS : 

3 THE CAPM ASSUMPTIONS ADDITIONAL ASSUMPTIONS one period investor horizon for all risk free rate is the same for all information is free and instantaneously available homogeneous expectations

THE CAPITAL MARKET LINE : 

4 THE CAPITAL MARKET LINE THE CAPITAL MARKET LINE (CML) the new efficient frontier that results from risk free lending and borrowing both risk and return increase in a linear fashion along the CML

THE CAPITAL MARKET LINE : 

5 THE CAPITAL MARKET LINE THE CAPITAL MARKET LINE M rP sP CML rfr

THE CAPITAL MARKET LINE : 

6 THE CAPITAL MARKET LINE THE SEPARATION THEOREM James Tobin identifies: the division between the investment decision and the financing decision

THE CAPITAL MARKET LINE : 

7 THE CAPITAL MARKET LINE THE SEPARATION THEOREM to be somewhere on the CML, the investor initially decides to invest and based on risk preferences makes a separate financing decision either to borrow or to lend

THE MARKET PORTFOLIO : 

8 THE MARKET PORTFOLIO DEFINITION: the portfolio of all risky assets which contains complete diversification a central role in the CAPM theory which is the tangency portfolio (M) with the CML

THE SECURITY MARKET LINE (SML) : 

9 THE SECURITY MARKET LINE (SML) FOR AN INDIVIDUAL RISKY ASSET the relevant risk measure is its covariance with the market portfolio (si, M) DEFINITION: the security market line expresses the linear relationship between the expected returns on a risky asset and its covariance with the market returns

THE SECURITY MARKET LINE (SML) : 

10 THE SECURITY MARKET LINE (SML) THE SECURITY MARKET LINE or where

THE SECURITY MARKET LINE (SML) : 

11 THE SECURITY MARKET LINE (SML) THE SECURITY MARKET LINE THE BETA COEFFICIENT an alternative way to represent the covariance of a security

THE SECURITY MARKET LINE (SML) : 

12 THE SECURITY MARKET LINE (SML) THE SECURITY MARKET LINE THE BETA COEFFICIENT of a portfolio is the weighted average of the betas of its component securities

THE SECURITY MARKET LINE (SML) : 

13 THE SECURITY MARKET LINE (SML) THE SECURITY MARKET LINE SML b E(r) rrf rM b =1.0

THE MARKET MODEL : 

14 THE MARKET MODEL FROM CHAPTER 7 assumed return on a risky asset was related to the return on a market index

THE MARKET MODEL : 

15 THE MARKET MODEL DIFFERENCES WITH THE CAPM the market model is a single-factor model the market model is not an equilibrium model like the CAPM the market model uses a market index, the CAPM uses the market portfolio

THE MARKET MODEL : 

16 THE MARKET MODEL MARKET INDICES the most widely used and known are S&P 500 NYSE COMPOSITE AMEX COMPOSITE RUSSELL 3000 WILSHIRE 5000 DJIA

THE MARKET MODEL : 

17 THE MARKET MODEL MARKET AND NON-MARKET RISK Recall that a security’s total risk may be expressed as

THE MARKET MODEL : 

18 THE MARKET MODEL MARKET AND NON-MARKET RISK according to the CAPM the relationship is identical except the market portfolio is involved instead of the market index

THE MARKET MODEL : 

19 THE MARKET MODEL MARKET AND NON-MARKET RISK Why partition risk? market risk related to the risk of the market portfolio and to the beta of the risky asset risky assets with large betas require larger amounts of market risk larger betas mean larger returns

THE MARKET MODEL : 

20 THE MARKET MODEL MARKET AND NON-MARKET RISK Why partition risk? non-market risk not related to beta risky assets with larger amounts of seI will not have larger E(r) According to CAPM investors are rewarded for bearing market risk not non-market risk

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