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 LuIntroductionModern Portfolio Theory and diversificationBeta vs. standard deviationUnsystematic vs. systematic riskSecurity Market Line (SML)The CAPM equationAsset pricingAssumptions behind using CAPMModern Portfolio Theory and diversificationRational investors use diversification to optimize their portfoliosDiversification reduces portfolio risk (assets that are not perfectly correlated)Efficient PortfolioBeta vs. standard deviationStandard deviation includes systematic and unsystematic risk; not used because unsystematic risk diversified awayBeta: 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 riskUnsystematic risk: risk that can be eliminated through diversificationa.k.a. Unique risk, residual risk, specific risk, or diversifiable riskSystematic risk: risk that cannot be eliminated through diversificationa.k.a, market risk or undiversifiable riskSecurity Market LineLine representing the relationship between expected return and market risk; shows expected return of an overall market as a function of systematic riskGraphical representation of CAPMCompare 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 #1If 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: answerIf 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 #2A 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: answerA 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 pricingFuture cash flows of the asset can be discounted using the expected return calculated from CAPM to establish the price of the assetIf observed price > CAPM valuation overvalued (paying too much for that amount of risk)If observed price < CAPM valuation undervaluedAssumptions behind the CAPMU.S. treasuries are risk-freeUncertainty about inflationAssumed that investors can borrow money at same interest rate at which they lend, but generally borrowing rates are higher than lending ratesWHY we still use CAPM: benchmark portfolios used Treausry bills and market portfolioPractice Problem #3Last year…Firm A: return: 10%, beta: 0.8Firm B: return: 11%, beta: 1.0Firm C: return: 12%, beta: 1.2Given that the risk-free rate was 3% and market return was 11%, which firm had the best performance?Practice Problem #3: answerFirm 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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