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Chapter 9

Charles P. Jones, Investments: Principles and Concepts,

Twelfth Edition, John Wiley & Sons

91

Describes how investors could behave not how

they should be have

between the risk and expected return on

risky assets

Builds on Markowitz portfolio theory

Each investor is assumed to diversify his or

her portfolio according to the Markowitz

model

92

Assumes all

investors:

Use the same

information to

generate an efficient

frontier

Have the same oneperiod time horizon

Can borrow or lend

money at the risk-free

rate of return

No transaction costs,

no personal income

taxes, no inflation

No single investor

can affect the price

of a stock

Capital markets are

in equilibrium

93

Lending

No correlation with risky assets

Usually proxied by a Treasury security

changes the efficient frontier

Lending because investor lends money to

issuer

With borrowing, investor no longer

restricted to own wealth

94

be combined with

L

any portfolio in the

B

efficient set AB

E(R)

Z implies lending

T

Z

RF

A

Set of portfolios on

line RF to T

dominates all

portfolios below it

Risk

9-5

new set of expected return-risk possibilities

Addition of risk-free asset results in

straight line tangent to the feasible set without

the riskless asset

Chosen portfolio depends on investors risk-return

preferences

96

L

M

E(RM)

x

RF

M

Risk

Line from RF to L is

capital market line

(CML)

x = risk premium

=E(RM) - RF

y =risk =M

Slope =x/y

=[E(RM) - RF]/M

y-intercept = RF

9-7

for efficient portfolios, or the equilibrium

price of risk in the market

Relationship between risk and expected

return for portfolio P (Equation for CML):

E(RM ) RF

E(Rp ) RF

p

M

98

The portfolio of all risky assets is the optimal risky

portfolio (called the market portfolio)

The expected price of risk is always positive

The optimal portfolio is at the highest point of

tangency between RF and the efficient frontier

All investors hold the same optimal portfolio of

risky assets

99

completely diversified

Includes only systematic risk

portfolio of all common stocks

In turn approximated with S&P 500

market value

910

an indifference curve) to determine optimal

portfolio

Separation Theorem

to hold is separate from the financing decision

Investment decision does not involve investor

Financing decision depends on investors preferences

911

equilibrium and efficient portfolios

The Security Market Line depicts tradeoff

between risk and expected return for

individual securities

Under CAPM, all investors hold the market

portfolio

covariance with the market portfolio

912

Beta

Standardized measure of systematic risk

Relative measure of risk: risk of an

individual stock relative to the market

portfolio of all stocks

Relates covariance of an asset with the

market portfolio to the variance of the

Covi, M

market portfolio

913

Beta

SM

L

E(R)

kM

kRF

as risky as market

Securities A and B

are more risky than

the market

Beta >1.0

Security C is less

risky than the

0.5 1.0 1.5 2.0 market

BetaM

Beta <1.0

9-14

composed of

risk-free rate (RF)

risk premium (i [ E(RM) - RF ])

ki = RF +i [ E(RM) - RF ]

required return

915

Expected market return unobservable

an expected value

Only company-specific factor in CAPM

Requires asset-specific forecast

916

Market model

Relates the return on each stock to the return on

the market, assuming a linear relationship

Produces an estimate of return for any stock

Ri = i + i RM +ei

Characteristic line

Line fit to total returns for a security relative to

total returns for the market index

917

Estimating a future beta

assets in the economy

Approximated with a stock market index

Approximates return on all common stocks

918

time periods for calculating beta

Therefore, estimates of beta vary

and from the characteristic line are

subject to estimation error

Portfolio betas more reliable than individual

security betas

919

Tests of CAPM

Assumptions are mostly unrealistic

Empirical evidence has not led to consensus

However, some points are widely agreed

upon

Intercept is generally higher than RF

Slope of the CAPM is generally less than theory

predicts

Its likely that only systematic risk is rewarded

920

different prices

Equilibrium prices adjust to eliminate all arbitrage

opportunities

personal taxes, riskless borrowing or lending,

mean-variance decisions

921

model

Factor Characteristics

stock returns

Risk factors must influence expected return and

have non-zero prices

Risk factors must be unpredictable to the market

922

factors from their expected values

Expected return is directly related to sensitivity

CAPM assumes risk is only sensitivity to market

APT can be described as:

E(Ri) =RF +bi1 (risk premium for factor 1)

+bi2 (risk premium for factor 2) +

+bin (risk premium for factor n)

923

To implement the APT model, need the factors

that account for the differences among security

returns

CAPM identifies market portfolio as single factor

in market

Focus on cash flows and discount rate

expectations

924

All rights reserved. Reproduction or translation of this

work beyond that permitted in section 117 of the

1976 United States Copyright Act without express

permission of the copyright owner is unlawful.

Request for further information should be addressed

to the Permissions Department, John Wiley & Sons,

Inc. The purchaser may make back-up copies for

his/her own use only and not for distribution or resale.

The Publisher assumes no responsibility for errors,

omissions, or damages caused by the use of these

programs or from the use of the information herein.

925

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