1. Capital Market Theory (Chap 9,10 of RWJ) 2003,10,16

2. Returns Dollar returns: terminal market value – initial market value Percentage returns=dollars returns/initial market value Dividend yield=dividend at end of period / present price Capital gain= price change of stock / initial price Total returns= dividend yield + capital gains

3. Holding period returns (1+R1)(1+R2)…(1+RT) for T years Small-company Large-company Long-term government bonds Treasury bill inflation

4. Average stock return and risk-free return Risk-free return: Risk premium = excess return on the risky asset = risky asset return – risk-free return Risky returns as a normal distribution

5. Expected return Variance Covariance Correlation Expected return of a portfolio is the weighted sum of individual expected return.

6. Diversification effect As long as correlation <1, the standard deviation of a portfolio of two securities is less than the weighted average of the standard deviations of the individual securities. Extend to more securities.

7. Efficient set (efficient frontier) for two assets Minimize variance of portfolio for constant expected mean.

8. Limit of reduced variance Portfolio who contains all assets. Variance as “ risk”. Total risk of individual security = portfolio risk (systematic risk) + diversifiable risk (or unsystematic risk)

9. Market equilibrium In a world of homogeneous expectations, all investors would hold the portfolio of risky assets Market portfolio: market-value-weighted portfolio of all existing portfolio.

10. Beta Beta measures the responsiveness of a security to movements in the market portfolio Beta_i=Cov(R_i,R_M)/Sigma^2(R_M)

11. Relation between risk and expected return (CAPM) R_M=R_F+ Risk premium R=R_F+Beta(R_M-R_F) Beta=0: riskless asset Beta=1: Market portfolio