Investments Chapter 9: CAPM

Market Portfolio

Contains all securities and the proportion of each security is its market value as a percentage of total market value All investors will hold the same portfolio for risky assets

Reward to Risk Ratio

E(Rm)/Variance of Market

Assumptions of CAPM- Markets

1. All assets are publicly held 2. All information is available 3. No taxes 4. No transaction costs

CAPM and the Academic World

1. Cannot observe all tradeable assets 2. Impossible to pin down market portfolio 3. Attempts to validate using regression analysis

Assumptions of CAPM- Individuals

1. Mean-variance optimizers 2. Homogeneous expectations 3. All assets are publicly traded

CAPM and the Investment Industry

1. Relies on the single-index CAPM model 2. Most investors don't beat the index portfolio

Beta coefficient is the

Covariance of the asset with the market portfolio as a fraction of the variance of the market portfolio

Illiquidity Premium

Discount from fair market value the seller must accept to obtain a quick sale. -Measured partly by bid-ask spread -As trading costs are higher, the illiquidity discount will be greater

Zero-Beta Model

Helps to explain positive alphas on low beta stocks and negative alphas on high beta stocks Consideration of labor income and non-traded assets

Which researchers are credited with CAPM's development

Markowitz, Sharpe, Lintner and Mossin

Assumptions about CAPM

Same risk-free rate, tangent CAL and risky portfolio Investors use identical input list for efficient frontier

Market Risk Premium

The difference between the expected return on a market portfolio and the risk-free rate

Liquidity

The ease and speed with which an asset can be sold at fair market value

If the market portfolio is efficient and the average investor neither borrows nor lends, THEN...

The risk premium on the market portfolio is proportional to its variance and to the average coefficient of risk aversion across investors

The market risk premium is equal to...

The slope of the security market line (SML), a graphical representation of the capital asset pricing model (CAPM).

Single-Index Model

To move from expected to realized returns use the index model in excess return form The index model beta coefficient is the same as the beta of the CAPM expected return-beta relationship

CAPM market portfolio is a _________weighted portfolio

Value Each security is held in proportion equal to its market value divided by the total market value of all securities

Market portfolio is the aggregation of

all risky portfolios and has the same weights

CAPM assumes that investors...

are single-period planners who agree on a common input list from security analysis and seek mean-variance optimal portfolios

The risk premium on individual securities is a

function of the individual security's contribution to the risk of the market portfolio. An individual security's risk premium is a function of the covariance of returns with the assets that make up the market portfolio.

The risk premium on the market portfolio will be...

proportional to its risk and the degree of risk aversion of the investor

CAPM implies that the risk premium on any individual asset or portfolio is the product of the...

risk premium on the market portfolio and the beta coefficient

CAPM holds that in equilibrium

the market portfolio is the unique mean-variance efficient tangency portfolio. Thus a passive strategy is efficient