TheCapitalAssetPricingModel(Chapter8).ppt

The Capital Asset Pricing Model (Chapter 8) Premise of the CAPM Assumptions of the CAPM Utility Functions The CAPM With Unlimited Borrowing and Lending at a Risk-Free Rate of Return Capital Market Line Versus Security Market Line Relationship Between the SML and the Characteristic Line The CAPM With No Risk-Free Asset The CAPM With Lending at the Risk-Free Rate, but No Borrowing The CAPM With Lending at the Risk-Free Rate, and Borrowing at a Higher Rate Market Efficiency Premise of the CAPM The Capital Asset Pricing Model (CAPM) is a model to explain why capital assets are priced the way they are. The CAPM was based on the supposition that all investors employ Markowitz Portfolio Theory to find the portfolios in the efficient set. Then, based on individual risk aversion, each of them invests in one of the portfolios in the efficient set. Note, that if this supposition is correct, the Market Portfolio would be efficient because it is the aggregate of all portfolios. Recall Property I - If we combine two or more portfolios on the minimum variance set, we get another portfolio on the minimum variance set. One Major Assumption of the CAPM Investors can choose between portfolios on the basis of expected return and variance. This assumption is valid if either: 1. The probability distributions for portfolio returns are all normally distributed, or 2. Investors’ utility functions are all in quadratic form. If data is normally distributed, only two parameters are relevant: expected return and variance. There is nothing else to look at even if you wanted to. If utility functions are quadratic, you only want to look at expected return and variance, even if other parameters exist. Evidence Concerning Normal Distributions Returns on individual stocks may be “fairly” normally distributed using monthly returns. For yearly returns, however, distributions of returns tend to be skewed