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Objectives:

Objectives:. Understand assumptions of the CAPM. Understand implications of the CAPM. Reading: Grinold & Kahn, chapter 2. Live Market Example. Remember the Island?. Capital Asset Pricing Model.

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Objectives:

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  1. Objectives: • Understand assumptions of the CAPM. • Understand implications of the CAPM. • Reading: Grinold & Kahn, chapter 2

  2. Live Market Example

  3. Remember the Island?

  4. Capital Asset Pricing Model • Introduced by Jack Treynor, William Sharpe, John Lintner and Jan Mossin (1966). • Sharpe, Markowitz and Merton Miller jointly received the Nobel Prize.

  5. CAPM: Assumptions • Return on stock has two components: • Systematic (the market) • Residual • Expected value of residual = 0 • Market return: • Risk free rate of return + • Excess return

  6. The Market Portfolio • Usually broad market-cap weighted index • US: S&P 500 • UK: FTA • Japan: TOPIX • Remember our company that printed $1 bills? • Island analogy.

  7. Next Time More formalities

  8. Beta & Correlation with the Market • Online example

  9. Beta & Correlation with Market

  10. CAPM: Definition of Beta • Assume: • rp(t) = betap * rm(t) + alphap • Use linear regression (line fitting) to find beta and alpha.

  11. CAPM: Residual = 0 • rp(t) = betap * rm(t) + alphap • rp(t) = betap * rm(t)

  12. CAPM: Implications • Expected excess returns are proportional to beta. • beta of a portfolio = weighted sum of betas of components.

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