Chapter7CapitalAssetPricingModelandArbitragePricing.pptVIP

* * * * * * McGraw-Hill/Irwin ? 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 6-* McGraw-Hill/Irwin Copyright ? 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 7: Capital Asset Pricing Model and Arbitrage Pricing Theory In Chapter 6, we showed how a single-factor model could be used to estimate the 2 components of risk (“market” and “firm-specific”) for a security. In Chapter 7, we’ll discuss the most commonly used single-factor model Capital Asset Pricing Model (CAPM): a model that relates the required rate of return for a security to its risk as measured by beta Then we’ll discuss how CAPM can be used to calculate risk premiums, alpha, and underpriced and overpriced securities. Then we’ll briefly introduce Multi-factor pricing models Arbitrage pricing theory (APT) Capital Asset Pricing Model (CAPM) Equilibrium model that underlies all modern financial theory Derived using principles of diversification with simplified assumptions Markowitz, Sharpe, Lintner and Mossin are researchers credited with its development (early 1970’s) CAPM is a theoretical economic model that requires these assumptions: Individual investors are price takers Single-period investment horizon Investments are limited to traded financial assets No taxes nor transaction costs Information is costless and available to all investors Investors are rational mean-variance optimizers Homogeneous expectations Capital Asset Pricing Model (CAPM) Resulting Equilibrium Conditions All investors will hold the same portfolio for risky assets (market portfolio) Market portfolio contains all securities and the proportion of each security is its market value as a percentage of total market value Risk premium on the market depends on the average risk aversion of all market participants Risk premium on an individual security is a function of its covariance with the market CAPM implies the expected-return-beta relationship