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Essentials of Investments
Fourth
Edition
Chapter 8
McGraw-Hill
Essentials of Investments
Fourth
Edition
Irwin
McGraw-Hill
Essentials of Investments
Fourth
Edition
Assumptions
Individual investors are price takers
Single-period investment horizon
Investments are limited to traded
financial assets
No taxes, and transaction costs
Irwin
McGraw-Hill
Essentials of Investments
Fourth
Edition
Assumptions (cont.)
Information is costless and available to
all investors
Investors are rational mean-variance
optimizers
Homogeneous expectations
Irwin
McGraw-Hill
Essentials of Investments
Fourth
Edition
Irwin
McGraw-Hill
Essentials of Investments
Fourth
Edition
Irwin
McGraw-Hill
Essentials of Investments
Fourth
Edition
E(rM)
CML
rf
m
Irwin
McGraw-Hill
Essentials of Investments
Fourth
Edition
=
=
=
Market portfolio
Risk free rate
Market risk premium
E(rM) - rf
Irwin
McGraw-Hill
Essentials of Investments
Fourth
Edition
McGraw-Hill
10
Essentials of Investments
Fourth
Edition
McGraw-Hill
11
Essentials of Investments
Fourth
Edition
SML Relationships
= [COV(ri,rm)] / m2
Slope SML =
E(rm) - rf
Irwin
McGraw-Hill
12
Essentials of Investments
Fourth
Edition
McGraw-Hill
13
Essentials of Investments
Fourth
Edition
.08
.6 1.0 1.25
y m x
Irwin
McGraw-Hill
14
Essentials of Investments
Fourth
Edition
Disequilibrium Example
E(r)
SML
15%
Rm=11%
rf=3%
1.0 1.25
Irwin
McGraw-Hill
15
Essentials of Investments
Fourth
Edition
Disequilibrium Example
Suppose a security with a of 1.25 is
offering expected return of 15%
According to SML, it should be 13%
Underpriced: offering too high of a rate
of return for its level of risk
Irwin
McGraw-Hill
16
Essentials of Investments
Fourth
Edition
.
.
.
.
.
.
. . .
.
.
.
.
.
.
.
.
.
.
.
. .
.
.
Excess returns
.
.
.
on market index
.
.
.
.
.
.
.
.
.
. . . .
.
.
.
.
.
.. . . .
Ri = i + i Rm + e i
Irwin
McGraw-Hill
17
Essentials of Investments
Fourth
Edition
McGraw-Hill
Excess
GM Ret.
Excess
Mkt. Ret.
5.41
-3.44
.
.
2.43
-.60
4.97
7.24
.93
.
.
3.90
1.75
3.32
2001 The McGraw-Hill Companies, Inc. All
18
Essentials of Investments
Fourth
Edition
Regression Results:
rGM - rf =
+ (rm - rf)
McGraw-Hill
1.1357
(0.309)
19
Essentials of Investments
Fourth
Edition
McGraw-Hill
20
Essentials of Investments
Fourth
Edition
Irwin
McGraw-Hill
Expected
Return%
25.0
20.0
32.5
22.5
Standard
Dev.%
29.58
33.91
48.15
8.58
21
Essentials of Investments
Fourth
Edition
Arbitrage Portfolio
Portfolio
A,B,C
D
Irwin
McGraw-Hill
Mean
Return
Stan.
Dev.
Correlation
Of Returns
25.83
6.40
0.94
22.25
8.58
22
Essentials of Investments
Fourth
Edition
McGraw-Hill
23
Essentials of Investments
Fourth
Edition
Irwin
McGraw-Hill