Chapter 18 CAPITAL ASSET PRICING THEORY

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Presentation transcript:

Chapter 18 CAPITAL ASSET PRICING THEORY What is the capital market line (CML)? How is the Capital Asset Pricing Model (CAPM) developed? What is the difference between the standard deviation risk and beta risk measures? How can an investor apply the CAPM to security analysis? How do you estimate beta? What are the good news and the bad news about beta? Contemporary Investments: Chapter 18

Assumptions of the Capital Asset Pricing Model Investors have homogeneous expectations Frictionless capital markets Investors are rational and seek to maximize their expected utility functions Investment is for one-period only All investors can borrow or lend at the riskfree rate Contemporary Investments: Chapter 18

Efficient frontier and the optimal risky portfolio Developing the capital market line (CML) Introducing the riskfree asset. The capital market line (CML) or the borrowing-lending line. The Portfolio Separation Theorem The market portfolio, M Contemporary Investments: Chapter 18

Figure 18.1 – Efficient Frontier Contemporary Investments: Chapter 18

Contemporary Investments: Chapter 18 Figure 18.2 – Efficient Frontier and Utility Curves for Investors A and B Contemporary Investments: Chapter 18

Contemporary Investments: Chapter 18 Figure 18.3 – Combinations of the Risk-Free Asset RF and Risky Portfolios P1 and P2 Contemporary Investments: Chapter 18

Contemporary Investments: Chapter 18 Figure 18.4 – Combinations of the Risk-Free Asset RF and the Risky Portfolio M Contemporary Investments: Chapter 18

Figure 18.5 – CML and Individual Utility Curves Contemporary Investments: Chapter 18

Figure 18.6 – CML: The Borrowing-Lending Line Contemporary Investments: Chapter 18

Capital Asset Pricing Model Developing a relative risk measure Understanding beta Systematic risk or market risk Diversifiable risk or firm-specific risk Contemporary Investments: Chapter 18

Figure 18.7 – CML and Individual Securities Contemporary Investments: Chapter 18

Contemporary Investments: Chapter 18 CAPM derivation Security risk and return Reward for investing in a security Security risk Security’s reward-to-risk ratio Risk/return relationship The security market line (SML) Differences between the CML and SML Contemporary Investments: Chapter 18

Figure 18.8 – Security Market Line (SML) Contemporary Investments: Chapter 18

CAPM and security analysis Estimating the required return. Estimating the predicted return. Security analysis decision rule. Comparison with fundamental analysis. Contemporary Investments: Chapter 18

Contemporary Investments: Chapter 18 Estimating Beta Security characteristic line Information service beta estimates Calculating beta: Separating systematic risk from diversifiable risk. Differences between the SML and the security characteristic line Contemporary Investments: Chapter 18

Good news and bad news about Beta How reliable are beta estimates? Does beta really measure risk? The verdict on beta. Implications for investors Contemporary Investments: Chapter 18

Figure 18.9 – Security Market Line Analysis Contemporary Investments: Chapter 18

Figure 18.10 – Regression Analysis to Estimate Beta Contemporary Investments: Chapter 18