1. Capital market theory is used to develop a model for pricing risky assets based on certain assumptions about investors and markets.
2. A key assumption is the existence of a risk-free asset that has zero variability and is uncorrelated with other assets.
3. The Capital Asset Pricing Model (CAPM) uses the concept of systematic and unsystematic risk to determine the expected return of individual risky assets based on their relationship to the overall market portfolio.
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1. Capital market theory is used to develop a model for pricing risky assets based on certain assumptions about investors and markets.
2. A key assumption is the existence of a risk-free asset that has zero variability and is uncorrelated with other assets.
3. The Capital Asset Pricing Model (CAPM) uses the concept of systematic and unsystematic risk to determine the expected return of individual risky assets based on their relationship to the overall market portfolio.
1. Capital market theory is used to develop a model for pricing risky assets based on certain assumptions about investors and markets.
2. A key assumption is the existence of a risk-free asset that has zero variability and is uncorrelated with other assets.
3. The Capital Asset Pricing Model (CAPM) uses the concept of systematic and unsystematic risk to determine the expected return of individual risky assets based on their relationship to the overall market portfolio.
Copyright:
Attribution Non-Commercial (BY-NC)
Available Formats
Download as DOC, PDF, TXT or read online from Scribd
1. Capital market theory is used to develop a model for pricing risky assets based on certain assumptions about investors and markets.
2. A key assumption is the existence of a risk-free asset that has zero variability and is uncorrelated with other assets.
3. The Capital Asset Pricing Model (CAPM) uses the concept of systematic and unsystematic risk to determine the expected return of individual risky assets based on their relationship to the overall market portfolio.
Copyright:
Attribution Non-Commercial (BY-NC)
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Download as DOC, PDF, TXT or read online from Scribd
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Capital mkt theory is used to dev a model for pricing
risky assets. Assumptions: 1. All investors are markwitz efficient investors who want to target points on the efficient frontier. The exact location on the eff frontier depnds on the investrs risk retunr utility functn. 2. Investors can borrow or lend any amnt of money @ the risk free rate of return. It is always possibl to lend money @ the nominal risk free rate by purchasin risk free securities like tbills cds, bt it is not always possble to borrw @ thte risk fre rate. 3. All investors hav homogeneous expectations. They estimate identical probability distr for future rates of returns.this is not a realistic assumption 4.all investors hav the same one period time horizon such as one month, 6 mnths or 1yr. Ie, the model is develpd for a single hypothetical period 5. All investments are infinitely divisible. That means, it is possible to buy or sell fractional shares of any asset portfolio. 6. Ther r no taxes or transaction costs involved in buying or selling some assets. For eg, neither pension funds nor religious grps hav to pay taxes. Transaction costs on most financial instrumnents are less than 1% 7ther is no inflation or ne chnage ininterest rates or inflation is fully anticipated. 8. Capital mkts are in equillibrium situation. All assets are properly priced in line with their risk levels.
The major factor which is required to develop the model
is the risk free asset. Risk free asset is an asset with zero standard deviation. It has 0 correlation with all other risky assets. It provides risk free rate of return. It always lies on the vertical axis on the portfolio graph.
COVrfi = ∑[Rf – E(Rf)(Ri-E(Ri)]/(n-1)
If sd is zero, Rf = E(Rf) Therefore, cov = 0 Rrfi=0
There are two assets: one is risk free and the risky asset When combined, the expected return from the portfolio Wrf = weight of risk free 1- Wrf = weight of risky E(Rport) = Wrf(Rrf) + (1-Wrf)(E(Ri)) E(σ2port) = wrf2 σrf2+(1+Wrf)2 σi2 + 2Wrf(1-Wrf)COVrfi =(1+Wrf)2 σi2 E(σ port )= (1+Wrf) σi There is a linear relationship between portfolio standard deviation and standard deviation of risky assets.
Total risk of market portfolio consists of unsystematic
risk and systematic risk. Unsystematic risk is the unique risk of an individual asset and can be eliminated through diversification. The total risk of the market portfolio can be reduced by adding securities in the portfolio. As the number of securities increases, total risk decreases. But systematic risk cannot be diversified away and it is caused by various macroeconomic variables such as variability in the money supply, interest rate volatility, variability in the industrial productions, variability in corporate earnings and cash flows. CAPM is used to determine the expected or required rate of return on a risky asset. Whether an asset is overpriced or underpriced or properly valued can be determined using CAPM and Security Market Line. E(Ri) = Rf +β(Rm-Rf)
Systematic risk of a risky asset is its covariance with the
market portfolio β = covim/σ2m
σi= (σi/σm) x (co vim/σiσm)
covim = ∑(m – mbar)(I – ibar)/(n-1)
Any investor can choose any combination of the risk free
asset and risky asset along the line RFRA. It will give the higher return than any point below the point A on the efficient frontier. The portfolio possibilities along the line RFRB will provide higher return than any portfolio along the line RFRA. (If we draw another line which will be tangent to efficient frontier, it will provide greater return) This tangent point M, will provide the highest portfolio possibilities for the investors which will provide the highest return. This line is called Capital Market Line. Every investor will want to invest in portfolio M which leads all investors to invest at this point. If the investor wants to invest beyond the point M, he will take higher risk to get higher return. If an investor add leverage to the portfolio by borrowing money at the risk free rate and investing in the risky portfolio at M, what would be the return and risk? For eg, if an investor want to borrow an amount equal to 50% of his wealth, the effect on expected return and risk for his portfolio would be: E(Rprt) = Wrf x Rfr + (1-Wrf)E(Ri) = - 0.5 Rfr +(1-(-0.5))E(Ri) = -0.5 Rfr +1.5E(Ri)
The gross return increases by 50% but the investor must
pay the interest from the borrowed money. The the Rfr is 6% and E(Ri) on the risky asset is 12% = 15% E(σprt) = (1- Wrf)σi =(1-(-o.5)) σi = 1.5 σi Risk and return both increases
Risk averse investors lend part of their portfolio at the risk
free rate and invest the reminder amount in the market portfolio. Investors who prefer more risk try to borrow money at the risk free rate and invest everything in the market portfolio. So the decision to borrow or lend to obtain a point on the capital market line is a separate Financing decision based on the risk preference. This separation of the investment and financing decision is referred to as the Separation Theorem. CML leads all investors to invest in the M portfolio at tangent point which combines risk free asset and risky assets. Individual investors differ in position on the CML depending on risk preference.
