1. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: Capital Asset Pricing Model Copyright © 2004 by Thomas Ho and Sang Bin Lee. All rights reserved. The Oxford Guide to Financial Modeling Thomas S. Y. Ho and Sang Bin Lee

2. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: The Capital Asset Pricing Model 2 2.1 Real and Financial Sectors Tangible assets, commodities –metals, buildings, factories, inventories, Intangible assets –patents, branding Financial securities –Stocks, bonds, options, mortgages Role of a corporation –Economic units –Organization of a corporation

3. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: The Capital Asset Pricing Model 3 2.2 Stocks and Stock Market Dividends, capital gains –Announcement date, ex-dividends Types of orders –Market orders: immediate execution at the market price –Limit orders: wait for the execution at the stated price Factors affecting the bid ask spreads –Market makers, competition, trading volume

4. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: The Capital Asset Pricing Model 4 Spot Market Primary market –new issuance –Investment banking Secondary market: –Exchanges: central location, specialists –Over-the-counter Open limit order book Market makers Electronic Communication Network (ECN)

5. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: The Capital Asset Pricing Model 5 Future and Forward Markets Forward contracts Futures contracts Counter-parties Open interests Marking to market Indices: S&P 500, Nikkei 225

6. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: The Capital Asset Pricing Model 6 2.3 Perfect Capital Market All financial claims are perfectly divisible No transaction costs No taxes Competitive markets No limit in short selling Information symmetry Increasing utility of wealth and risk aversion

7. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: The Capital Asset Pricing Model 7 2.4 Efficient Capital Market Hypothesis Weak form efficiency Semi-strong form efficiency Strong form efficiency

8. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: The Capital Asset Pricing Model 8 2.4 Efficient Capital Market Hypothesis

9. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: The Capital Asset Pricing Model 9 2.5 Diversification A portfolio in general reduces the risk of an individual stock Contribution of risk from each stock A measure of risk: standard deviation The example of 2 coins shows that the standard deviation is lowered in betting on 2 coins than putting all the bet on one coin

10. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: The Capital Asset Pricing Model 10 Diversification (an Example) Head/HeadHead/TailTail/Tail Probability0.250.50.25 Outcomes$200$1000

11. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: The Capital Asset Pricing Model 11 Lognormal and normal distributions with a mean and a standard deviation -1.96 0 1.96 0.1 0.2 0.3 0.4 Normal Density 0.2311.7 0.1 0.2 0.3 0.4 Lognormal Density

12. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: The Capital Asset Pricing Model 12 Diversification Effect

13. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: The Capital Asset Pricing Model 13 Diversification Effect the average risk of portfolios :

14. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: The Capital Asset Pricing Model 14 Diversification Effect

15. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: The Capital Asset Pricing Model 15 Capital Asset Pricing Model

16. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: The Capital Asset Pricing Model 16 Capital Market Line CML A BC M 0 E D

17. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: The Capital Asset Pricing Model 17 the variance of the market portfolio

18. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: The Capital Asset Pricing Model 18 2.7 Beta – the Systematic Risk

19. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: The Capital Asset Pricing Model 19 Security Market Line: relationship between expected return and beta

20. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: The Capital Asset Pricing Model 20 The Constant Growth Stock Model S the stock price D the dividends The required return of the stock The constant growth rate

21. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: The Capital Asset Pricing Model 21 2.8 The Dividend Discount Model

22. The Oxford Guide to Financial Modeling by Ho & Lee Chapter 2. Equity Market: The Capital Asset Pricing Model 22 2.10 Empirical Tests of the Capital Asset Pricing Model Black, Jensen, Scholes (1972) Fama and Macbeth (1974) –Relate the stock betas with the long term stock returns Roll (1977) –Is CAPM testable? Stambaugh(1982) –What is the market portfolio?