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Lecture 10

MGT 200 Lecture 10: Chapter 7 Book

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Western Kentucky University
MGT 200

CAPM predicts the relationship between the risk of an asset and its expected return Assume alpha is zero – no firm specific risk, so we have to have systematic risk Want a portfolio indexed to the broad market 1. Markets a re competitive and profitable to all investors 2. No investor can be a price taker 3. All information is publicly available 4. All risky assets are in the investment universe 5. No taxes and no transaction costs 6. Borrow and lend at the risk free rate All investors choose to hold the market portfolio of all assets in the universe Proportion of ach stock in the portfolio = MV of stock / total MV of all stocks Market portfolio is on the efficient frontier as the optimal risky portfolio (tangency point on the CAL line) The line through the rf rate to the market portfolio (CML) is also optimal) The risk premium on assets will proportional to market portfolio rp and beta (how returns respond relative to the market) Everyone holds the same risky portfolio  CAL line becomes the capital market line Mutual fund theorem- only one mutual fund of risky assets, market index fund, can satisfy investment demands of all investors The equibilirmium risk remium of the market portfolio is proportional to the degree of risk aversion of the average investors and the risk of the market portfolio Investors buy stocks and that demand drives up prices which lowers the rate of return When risk premiums fall because of this, investors move into the risk free asset Have to have a happy medium of risk premium – too high and they hold stocks, too low and they don’t hold stocks so the prices fall Risk free rate = 5% and risk aversion coefficient = 2 and st dev of market portfolio = 20% Market risk premium = 2 x .2^2 = .08 So the expected rate of return = .05 + .08
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