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CHAPTER 9
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CAPM Assumptions
All investors: Use the same information to generate an efficient frontier Have the same one-period time horizon Can borrow or lend money at the risk-free rate of return No transaction costs, no
personal income taxes, no inflation No single investor can affect the price of a stock Capital markets are in equilibrium
Risk-Free Lending
Riskless assets can be
E(R) Z RF A X
combined with any portfolio in the efficient set B AB Set of portfolios on line RF to T dominates all portfolios below it
Risk
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Borrowing Possibilities
Investor no longer restricted to own wealth
Interest paid on borrowed money Higher returns sought to cover expense Assume borrowing at RF
Risk will increase as the amount of borrowing increases Financial leverage
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feasible set without the riskless asset Chosen portfolio depends on investors risk-return preferences
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Portfolio Choice
The more conservative the investor the more is placed in risk-free
lending and the less borrowing The more aggressive the investor the less is placed in risk-free lending and the more borrowing
Most aggressive investors would use leverage to invest more in portfolio T
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Market Portfolio
Most important implication of the CAPM All investors hold the same optimal portfolio of risky assets The optimal portfolio is at the highest point of tangency between RF and the efficient frontier The portfolio of all risky assets is the optimal risky portfolio
Called the market portfolio
risk for efficient portfolio SML : equilibrium relationship between expected return and systematic risk
y
RF x M Risk
capital market line (CML) y = risk premium = E(RM) - RF x = risk = M Slope = y/x = [E(RM) - RF]/M y-intercept = RF
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from the financing decision (how to allocate investable funds between risk-free & risky assets) Pg. 238
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portfolios, or the equilibrium price of risk in the market Relationship between risk and expected return for portfolio P (Equation for CML):
E(RM ) RF E(R p ) RF p M
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E(Ri ) RF i E(RM ) RF
Beta measures systematic risk Measures relative risk compared to the market portfolio of all stocks Volatility different than market
kRF
the market
0 0.5 1.0 1.5 BetaM 2.0
Beta <1.0
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ki = RF +i [ E(RM) - RF ]
The greater the systematic risk, the greater the required return
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as is the CAPM, which predicts than only market risks influences E(R) Based on the Law of One Price
Two otherwise identical assets cannot sell at different prices Equilibrium prices adjust to eliminate all arbitrage opportunities
Assumptions
CAPM Single period investment horizon Absence of taxes Borrowing and lending at rate of RF Investor selects portfolios on the basis of expected return and variance Investor have homogenous beliefs Investor are risk averse utility maximizers Markets are perfect Return are generated by a factor model APT 4 terakhir
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Factor Models
Major factors in economy that affect large number of securities
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APT Model
The expected return-risk relationship for the APT can be
described as: E(Ri) =RF +bi1 (risk premium for factor 1) +bi2 (risk premium for factor 2) + +bin (risk premium for factor n)