CHAPTER NINE THE CAPITAL ASSET PRICING MODEL

THE CAPM ASSUMPTIONS n 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 n 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 n 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 M rPrP PP CML rfr

THE CAPITAL MARKET LINE n THE SEPARATION THEOREM James Tobin identifies: 3 the division between the investment decision and the financing decision

THE CAPITAL MARKET LINE n THE SEPARATION THEOREM to be somewhere on the CML, the investor initially 3 decides to invest and 3 based on risk preferences makes a separate financing decision either – to borrow or – to lend

THE MARKET PORTFOLIO n 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) n FOR AN INDIVIDUAL RISKY ASSET the relevant risk measure is its covariance with the market portfolio (  i, M ) DEFINITION: the security market line expresses the linear relationship between 3 the expected returns on a risky asset and 3 its covariance with the market returns

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

THE SECURITY MARKET LINE (SML) n THE SECURITY MARKET LINE THE BETA COEFFICIENT 3 an alternative way to represent the covariance of a security

THE SECURITY MARKET LINE (SML) n THE SECURITY MARKET LINE THE BETA COEFFICIENT 3 of a portfolio – is the weighted average of the betas of its component securities

THE SECURITY MARKET LINE (SML) THE SECURITY MARKET LINE SML  E(r) r rf rMrM 

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

THE MARKET MODEL n 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 n MARKET INDICES the most widely used and known are 3 S&P NYSE COMPOSITE 3 AMEX COMPOSITE 3 RUSSELL WILSHIRE DJIA

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

THE MARKET MODEL n MARKET AND NON-MARKET RISK according to the CAPM 3 the relationship is identical except the market portfolio is involved instead of the market index

THE MARKET MODEL n MARKET AND NON-MARKET RISK Why partition risk? 3 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 n MARKET AND NON-MARKET RISK Why partition risk? 3 non-market risk – not related to beta – risky assets with larger amounts of   I will not have larger E(r) 3 According to CAPM – investors are rewarded for bearing market risk not non-market risk

END OF CHAPTER 9