2006 CMA Topic 3 Capital Asset Pricing Model.ppt

* Capital Markets Analysis Week 5: Capital Asset Pricing Model Preview Standard Capital Asset Pricing Model Assumptions Summary of implications Beta Security market line Sample exam questions Review The CAPM and Securities Analysis Problems Seminar Topics for Groups 1E and 2E Preview Asset allocation 1 (Capital allocation) Asset allocation 2 (Risky portfolio) Asset allocation 3 Perfect competition One period time horizon Investments comprise only publicly-traded financial assets including risk-free loans No taxes on returns or transaction costs Rational behaviour Homogeneous expectations Standard model Case 2 Case 3 Case 4 Case 5 Case 6 The Standard CAPM Model - assumptions - Case 2 Theory (standard case) Case 3 Case 4 Theory is (almost) never wrong But it may be irrelevant, inapplicable, out-of-date The Standard CAPM Model - summary of implications - The weights in each investor’s portfolio of risky assets are identical with the weights of these assets in the market portfolio (M) The capital market line (CML), the line from the risk-free asset through the market portfolio (M), is also the best attainable CAL The risk premium on the market portfolio is proportional to its risk and the degree of risk of the representative investor The risk premium on individual assets is proportional to the risk premium on the market portfolio (M) and the beta coefficient of the security relative to the market portfolio Individual Portfolios A B C D Market Portfolio 1,000 2,000 3,000 4,000 W1 = 0.1 W2 = 0.2 W3 = 0.3 W4 = 0.4 100 200 300 400 100 Loans Security 1 Security 2 Security 3 Security 4 200 400 600 800 200 300 600 900 1,200 300 W4 = 0.4 W3 = 0.3 W2 = 0.2 W1 = 0.1 -600 800 1,200 1,600 400 The Standard CAPM Model - implications: capital market line (CML) - E(r) σ E(rM) rf CML σM The efficient portfolio is the market portfolio!!! Market risk premium Market standard deviation M E(rM) – rf = 0.01 x ?σM2 Risk premium Average degree of risk aversion Variance of market port