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INVESTMENT MANAGEMENT
SESSION 2, 2012

Lecture 5: The Capital Asset Pricing Model

Last Week
2



Index models
Systematic and idiosyncratic risks  Calculating covariance




Case study
Calculating systematic and idiosyncratic risks  Investment strategies  Required return  Reward-to-risk ratio


Today
3

 

Asset pricing models: what and why The Capital Asset Pricing Model (CAPM)
Assumptions  The claim  Implications  The economic mechanism  The reality check  Applications  Extensions


Asset Pricing
4



Central issue: what is the “fair” or “required” return of a risky asset?


Sarah Wolfe of BMC Macro economy:
 



Why do we care?


Efficient capital allocation for growth Bubbles and crashes

Social welfare: Pension investments  Firms’ cost of capital  Performance evaluation:



Fund managers, trading strategies

Equilibrium Asset Pricing
5

E(Ri), i, ρij, i,j = 1,…N

Markowitz Portfolio Optimization

The minimum variance set (MVS) and the optimal risky portfolio

Capital Asset Pricing Model

The CAPM Assumptions
6



  



All investors are price takers, meanvariance optimisers, and have identical information and holding periods. All assets are marketable and divisible. The market portfolio includes ALL assets There is a single risk-free rate at which one can borrow or lend any amount No market imperfections (no taxes, short selling restriction, transaction costs, etc)

CAPM Conclusion
7



The market portfolio is the tangency portfolio on the efficient frontier:
Investors: Same model (Markowitz) + same input parameters = same tangency portfolio (The Separation Property)  Equilibrium: supply = demand Total shares issued by firms (market portfolio) = aggregate holdings of all investors (tangency portfolio)


CAPM Implications
8



The optimal portfolio for all investors is a combination of the risk-free asset and the

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