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    Capital Asset Pricing Model

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    isteaq ahamed
    The document provides an overview of the Capital Asset Pricing Model (CAPM). It describes the key assumptions of CAPM including perfect competition, a single period, no taxes or transaction costs, rational investors, and homogeneous expectations. It then outlines the three main equilibrium conditions of CAPM: 1) all investors hold the market portfolio, 2) the risk premium of the market portfolio is proportional to its risk and investor risk aversion, and 3) the risk premium of individual assets is proportional to the risk premium of the market portfolio and the asset's beta. The document concludes by comparing the single index model to CAPM.

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    Capital Asset Pricing Model

    Uploaded by

    isteaq ahamed
    51 views16 pages
    The document provides an overview of the Capital Asset Pricing Model (CAPM). It describes the key assumptions of CAPM including perfect competition, a single period, no taxes or transaction costs, rational investors, and homogeneous expectations. It then outlines the three main equilibrium conditions of CAPM: 1) all investors hold the market portfolio, 2) the risk premium of the market portfolio is proportional to its risk and investor risk aversion, and 3) the risk premium of individual assets is proportional to the risk premium of the market portfolio and the asset's beta. The document concludes by comparing the single index model to CAPM.

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    Lecture_6

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    The document provides an overview of the Capital Asset Pricing Model (CAPM). It describes the key assumptions of CAPM including perfect competition, a single period, no taxes or transaction costs, rational investors, and homogeneous expectations. It then outlines the three main equilibrium conditions of CAPM: 1) all investors hold the market portfolio, 2) the risk premium of the market portfolio is proportional to its risk and investor risk aversion, and 3) the risk premium of individual assets is proportional to the risk premium of the market portfolio and the asset's beta. The document concludes by comparing the single index model to CAPM.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    51 views16 pages

    Capital Asset Pricing Model

    Uploaded by

    isteaq ahamed
    The document provides an overview of the Capital Asset Pricing Model (CAPM). It describes the key assumptions of CAPM including perfect competition, a single period, no taxes or transaction costs, rational investors, and homogeneous expectations. It then outlines the three main equilibrium conditions of CAPM: 1) all investors hold the market portfolio, 2) the risk premium of the market portfolio is proportional to its risk and investor risk aversion, and 3) the risk premium of individual assets is proportional to the risk premium of the market portfolio and the asset's beta. The document concludes by comparing the single index model to CAPM.

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    You are on page 1of 16

    Capital Asset Pricing Model

    Chapter 9

    1
    Relevant sections from the textbook:
    Chapter 9: Section 9.1, Section 9.2

    CAPITAL ASSET PRICING MODEL

    2
    Capital Asset Pricing Model (CAPM)

    • It is the equilibrium model that underlies all


    modern financial Economics
    • Derived using principles of diversification
    with simplified assumptions
    • Markowitz, Sharpe, Lintner and Mossin are
    researchers credited with its development
    Main Assumptions behind CAPM
    • Perfect competition
    – There are many investors, each with a wealth that is small
    compared to the total wealth of all of the investors.
    – So, the investors are price-takers.
    • Single investment period
    • No taxes on returns
    • No transaction costs (commissions and service
    charges)
    • Investors are rational.
    – All investors use the Markowitz portfolio selection model
    • Investors have homogenous expectations
    4
    Resulting Equilibrium Conditions
    (1) All investors will hold the same optimal portfolio for
    risky assets – The market portfolio.
    – Market portfolio contains all securities and the proportion
    of each security is its market value as a percentage of total
    market value.

    5
    Resulting Equilibrium Conditions :

    (1) All investors will hold the same optimal portfolio for
    risky assets – The market portfolio.
     Suppose the optimum portfolio share of our investor
    does not include the stock of Delta Airlines. Delta’s
    stock price for example is p0
    • There would be zero demand for Delta's stock at p0
    • Price of Delta would have to fall
    • This would raise expected returns on Delta’s stock
    (given a certain anticipated stream of dividends),
    making Delta a more attractive investment

    6
    Resulting Equilibrium Conditions
    (2) The risk premium on the market portfolio will be
    proportional to its risk and the risk aversion of the
    representative investor.

    • A = Average degree of risk aversion across all the


    investors.

    7
    Resulting Equilibrium Conditions

    (3) The risk premium on individual assets will be


    proportional to the risk premium on the market
    portfolio (M) and the beta coefficient of the security
    relative to the market portfolio:

    8
    Example
    • What is the beta of a portfolio with E(rp) =
    18%, if rf=6% and E(rm)=14%?

    9
    Security Market Line
    • SML exhibits the expected return
    – beta relationship:

    • SML graphs the individual asset


    M
    risk premiums as a function of
    asset risk (beta).
    • Given the risk of an investment,
    SML provides the required rate
    of return for that investment.
    • Slope is equal to the risk
    premium of the market portfolio.

    10
    Security Market Line
    • SML exhibits the expected return
    – beta relationship:

    • Fairly priced assets would be


    located exactly on the SML.
    • If a stock is a good buy (i.e.
    underpriced), it would provide an
    expected return in excess of the
    fair return described by the SML.
    •  positive alpha stocks are a
    good buy…

    11
    Security Market Line

    • Notice, if alpha > 0, everyone


    wants to buy
    • Notice, if alpha < 0, everyone
    wants to sell
    • Hence price is not in
    equilibrium unless alpha = 0

    12
    Example
    • Would you buy a stock if the expected market return
    is 14%, beta of the stock is 1.2, the T-bill rate is 6%
    and you believe that the stock will provide an
    expected return of 17%?

    13
    Single Index Model and CAPM
    • Single Index Model:
    (ri - rf ) = α i + ßi(rm – rf) + ei

    • CAPM
    E(ri ) - rf = ßi [E(rm ) - rf)

    • What are the main differences between the


    equations summarizing the two models?

    14
    Single Index Model and CAPM
    • Single Index Model:

    (ri - rf ) = α i + ßi(rm – rf) + ei


    • What is the covariance between stock i and the
    market index:
    Cov (ri,rm) = ßißm m2

    15
    Single Index Model and CAPM
    • Important observation 1:
    – The index model beta coefficient is identical to the beta of
    the CAPM.
    • Now, get the expected value of the index model
    (ri - rf ) = α i + ßi(rm – rf) + ei

    • Important observation 2:
    – CAPM predicts that alpha should be zero for all assets.
    – Remember CAPM:
    E(ri ) - rf = ßi [E(rm ) - rf)

    16

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