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Lecture 8

FINC-212 Lecture Notes - Lecture 8: Market Risk, Capital Asset Pricing Model, Efficient-Market Hypothesis

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Kate Waldock

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FINC 212 Lecture 8
CAPM Theory and Assumptions
- The Role of the Marginal Investor
o The marginal investor in a firm is the investor that is most likely to be the next
buyer or seller on the next trade, and to influence the stock price
o Largest investor may not be the marginal trader (the CEO/Founder of a firm)
o All risk/return models in finance assume a well-diversified marginal investor
- The Market Portfolio
o Assuming there are no transaction costs, and all assets can be traded, the market
portfolio is a portfolio that holds every single asset in the economy
o Investors adjust for risk by adjusting their allocation between a market portfolio
and a riskless asset (such as a T-Bill)
- Risk of an Individual Asset
o Individual asset risk can be measured by how much asset returns move with the
market (covariance of its returns with the returns on a market index; or covariance
of the asset with the market, divided by the variance of the market)
- Limitations of the CAPM
o The model makes unrealistic assumptions
o The parameters of the model cannot be estimate precisely
The market index used can be wrong
The firm may have changed during the “estimation period”
o The model does not work well
The relationship between betas and returns is weak
Other variables explain differences better
Alternatives to the CAPM
- Arbitrage Pricing Model
o If there are no arbitrage opportunities then the market risk of an asset must be
captured by betas relative to factors that affect all investments
o Market Risk = Risk exposures of any asset to market factors, from factor analysis
- Multi-Factor Models
o Market risk must come from macroeconomic factors, since market risk affects all
investment indiscriminately
o Market Risk = Risk exposures of any asset to macroeconomic factors
- Proxy Models
o In an efficient market, differences in returns across long periods must be due to
market risk differences, so looking for variables correlated with returns should
give us proxies for these risks
o Market Risk = Captured, or at least imitated by proxy variables
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