CHAPTER TENTHE CAPM ASSUMPTIONSSlide 3THE CAPITAL MARKET LINESlide 5Slide 6Slide 7THE MARKET PORTFOLIOTHE SECURITY MARKET LINE (SML)Slide 10Slide 11Slide 12Slide 13THE MARKET MODELSlide 15Slide 16Slide 17Slide 18Slide 19Slide 201CHAPTER TENTHE CAPITAL ASSET PRICING MODEL2THE CAPM ASSUMPTIONS•NORMATIVE ASSUMPTIONS–expected returns and standard deviation cover a one-period investor horizon–nonsatiation–risk averse investors–assets are infinitely divisible–risk free asset exists–no taxes nor transaction costs3THE CAPM ASSUMPTIONS•ADDITIONAL ASSUMPTIONS–one period investor horizon for all–risk free rate is the same for all–information is free and instantaneously available–homogeneous expectations4THE CAPITAL MARKET LINE•THE CAPITAL MARKET LINE (CML)–the new efficient frontier that results from risk free lending and borrowing–both risk and return increase in a linear fashion along the CML5THE CAPITAL MARKET LINETHE CAPITAL MARKET LINEMrPPCMLrfr6THE CAPITAL MARKET LINE•THE SEPARATION THEOREM–James Tobin identifies:•the division between the investment decision and the financing decision7THE CAPITAL MARKET LINE•THE SEPARATION THEOREM–to be somewhere on the CML, the investor initially•decides to invest and•based on risk preferences makes a separate financing decision either–to borrow or–to lend8THE MARKET PORTFOLIO•DEFINITION: the portfolio of all risky assets which contains–complete diversification–a central role in the CAPM theory which is the tangency portfolio (M) with the CML9THE SECURITY MARKET LINE (SML)•FOR AN INDIVIDUAL RISKY ASSET–the relevant risk measure is its covariance with the market portfolio (i, M)–DEFINITION: the security market line expresses the linear relationship between• the expected returns on a risky asset and•its covariance with the market returns10THE SECURITY MARKET LINE (SML)•THE SECURITY MARKET LINEorwhere mimrfmrfrrrr,2Mirfrfirrrr,2)(2,,MMiMi11THE SECURITY MARKET LINE (SML)•THE SECURITY MARKET LINE–THE BETA COEFFICIENT•an alternative way to represent the covariance of a security12THE SECURITY MARKET LINE (SML)•THE SECURITY MARKET LINE–THE BETA COEFFICIENT•of a portfolio– is the weighted average of the betas of its component securitiesNiMiiMPX1,,13THE SECURITY MARKET LINE (SML)THE SECURITY MARKET LINESMLE(r)rrfrM 14THE MARKET MODEL•FROM CHAPTER 8–assumed return on a risky asset was related to the return on a market indextiItIiIiItirr,,,15THE MARKET MODEL•DIFFERENCES WITH THE CAPM–the market model is a single-factor model–the market model is not an equilibrium model like the CAPM–the market model uses a market index,–the CAPM uses the market portfolio16THE MARKET MODEL•MARKET INDICES–the most widely used and known are•S&P 500•NYSE COMPOSITE•AMEX COMPOSITE•RUSSELL 3000•WILSHIRE 5000•DJIA17THE MARKET MODEL•MARKET AND NON-MARKET RISK–Recall that a security’s total risk may be expressed as2222iIiIi18THE MARKET MODEL•MARKET AND NON-MARKET RISK–according to the CAPM•the relationship is identical except the market portfolio is involved instead of the market index19THE MARKET MODEL•MARKET AND NON-MARKET RISK–Why partition risk?•market risk–related to the risk of the market portfolio and to the beta of the risky asset–risky assets with large betas require larger amounts of market risk–larger betas mean larger returns20THE MARKET MODEL•MARKET AND NON-MARKET RISK–Why partition risk?•non-market risk–not related to beta–risky assets with larger amounts of I will not have larger E(r)•According to CAPM–investors are rewarded for bearing market risk not non-market