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The Capital Asset Pricing Model (CAPM)

This model gives us a precise prediction of the relationship that we should observe between the risk of an asset and its expected return

Market Portfolio

All traded assets

Capital Market Line

The line from the risk-free rate through the market portfolio, M. Graphs the risk premiums of efficient portfolios (i.e. portfolios composed of the market and the risk-free asset) as a function of portfolio standard eviation

efficient frontier

developed by Prof Harry Markowitz 1952

Mutual Fund Theorem

The passive strategy of investing in a market index portfolio is efficient. A passive investor may view the market index as a reasonable first approximation of an efficient risky portfolio

Market Price of Risk

Quantifes the extra return that investors demand to bear portfolio risk

beta

responsiveness of a stocks expected return to changes in teh value of the complete marekt portfolio of that stock

Security market line (SML)

a graphical representation of the CAPM with beta on the x-axis and expected return on the y-axis; slope of the line is the market risk premium (Rm - Rf)

Underpriced Stocks

Provide an expected return in excess of the fair return stipulated by the SML, therefore they plot above the SML

Alpha

The difference between the fair and actually expected rates of return on a stock

Market model

a regression equation that specifies a linear relationship between the return on a security (or portfolio) and the return on a broad market index

Frontier of Risky Portfolios

portfolios of risky assets offering the highest return for a given level of risk, or the lowest risk for a given level of return.

Capital Asset Pricing Model (CAPM)

a model that specifies the relationship between risk and expected return. In the CAPM model, the only risk that matters is nondiversifiable risk, also known as systematic risk or market risk, which is the varia…

Asset Allocation Decision

the decision as to how much money to put in risky assets and how much to put in risk-free assets. According to the CAPM model, the asset allocation decision is the most important decision inves…

Arbitrage Pricing Theory

a model of risk and expected return that includes multiple measures of systematic risk.

Separation

the notion that corporate decisions can be separated from the preferences of the individual stockholder.

The Capital Asset Pricing Model

CAPM can "price" (estimate RoR for individual securities using CAPM and then obtaining a price estimate

Pricing

Unlike the Capital Market Line the CAPM can price both

The CAPM's Main Assumptions

Investors are risk averse individuals who maximize the

The CAPM's Intuition

All investors hold efficient portfolios comprising the market portfolio, M and the riskfree security

The CAPM's Intuition continued

Expected return on A = Riskfree return + Risk premium

CAPM and Beta

βj = 1: Security (portfolio) has the same risk as the market portfolio

The Security Market Line

In equilibrium, all risky securities are priced so that their expected returns plot on the SML

The CML Versus the SML

SML can also be written as

Rjt = αj + βj

Estimating Betas Using the Market Model

Estimating the Other CAPM Parameters

Rf rate generally estimated as the yield to maturity on long term government bonds