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UIUC FIN 321 - Capital Asset Pricing Model

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CAPM Capital Asset Pricing ModelIntroductionModern Portfolio Theory and diversificationBeta vs. standard deviationUnsystematic vs. systematic riskSecurity Market LineSlide 7Capital Asset Pricing Model (CAPM)Practice Problem #1Practice Problem #1: answerPractice Problem #2Practice Problem #2: answerAsset pricingAssumptions behind the CAPMPractice Problem #3Practice Problem #3: answerCAPMCapital Asset Pricing ModelBy Martin Swoboda and Sharon LuIntroductionModern Portfolio Theory and diversificationBeta vs. standard deviationUnsystematic vs. systematic riskSecurity Market Line (SML)The CAPM equationAsset pricingAssumptions behind using CAPMModern Portfolio Theory and diversificationRational investors use diversification to optimize their portfoliosDiversification reduces portfolio risk (assets that are not perfectly correlated)Efficient PortfolioBeta vs. standard deviationStandard deviation includes systematic and unsystematic risk; not used because unsystematic risk diversified awayBeta: A standardized measure of the risk of an individual asset, one that captures only the systematic component of its volatility; measures how sensitive an individual security is to market movements; measure of market riskUnsystematic vs. systematic riskUnsystematic risk: risk that can be eliminated through diversificationa.k.a. Unique risk, residual risk, specific risk, or diversifiable riskSystematic risk: risk that cannot be eliminated through diversificationa.k.a, market risk or undiversifiable riskSecurity Market LineLine representing the relationship between expected return and market risk; shows expected return of an overall market as a function of systematic riskGraphical representation of CAPMCompare a single asset to the SML (and see if it falls below, above, or on the line)Security Market LineCapital Asset Pricing Model (CAPM)The expected return on a specific asset equalsthe risk-free rate plus a premium that dependson the asset’s beta and the expected risk premium on the market portfolio.Expected return of specific asset: E(Ri)Risk-free rate: RfExpected risk premium: E(Rm) - RfPractice Problem #1If the risk-free rate equals 4% and a stock with a beta of 0.8 has an expected return of 10%, what is the expected return on the market portfolio?Practice Problem #1: answerIf the risk-free rate equals 4% and a stock with a beta of 0.75 has an expected return of 10%, what is the expected return on the market portfolio?10% = 4% + 0.75(market portfolio – 4%)8% = market portfolio – 4%12% = market portfolioPractice Problem #2A particular asset has a beta of 1.2 and an expected return of 10%. Given that the expected return on the market portfolio is 13% and the risk-free rate is 5%, the stock is:A. appropriately pricedB. underpricedC. overpricedPractice Problem #2: answerA particular asset has a beta of 1.2 and an expected return of 10%. Given that the expected return on the market portfolio is 13% and the risk-free rate is 5%, the stock is:A. appropriately pricedB. underpricedC. overpriced; expected return should be 14.6% (5+1.2(13-5))Asset pricingFuture cash flows of the asset can be discounted using the expected return calculated from CAPM to establish the price of the assetIf observed price > CAPM valuation  overvalued (paying too much for that amount of risk)If observed price < CAPM valuation  undervaluedAssumptions behind the CAPMU.S. treasuries are risk-freeUncertainty about inflationAssumed that investors can borrow money at same interest rate at which they lend, but generally borrowing rates are higher than lending ratesWHY we still use CAPM: benchmark portfolios used  Treausry bills and market portfolioPractice Problem #3Last year…Firm A: return: 10%, beta: 0.8Firm B: return: 11%, beta: 1.0Firm C: return: 12%, beta: 1.2Given that the risk-free rate was 3% and market return was 11%, which firm had the best performance?Practice Problem #3: answerFirm A: 3% + 0.8(11%-3%) = 9.4% (over)Firm B: 3% + 1.0(8%) = 11% (same)Firm C: 3% + 1.2(8%) = 12.6% (under)Firm A performed the best because it exceeded the expected


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UIUC FIN 321 - Capital Asset Pricing Model

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