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Chapter 9

# Chapter 9 Notes

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University of Toronto Scarborough

Finance

MGFB10H3

Derek Chau

Fall

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Chapter 9 The Capital Asset Pricing Model (CAPM) Notes 9.1 The New Efficient Frontier The Efficient Frontier with Risk-Free Borrowing and Lending risk premium the expected payoff that induces a risk-averse person to enter into a risky situation generally, investor behaviour is consistent with risk aversion and existence of risk premiums to induce individuals to bear risk insurance premium the payment to get out of a risky situation the existence of insurance markets indicates how risk aversion creates a demand to remove risk, whereas the existence of capital markets indicates how risk aversion generates the risk premiums required to induce people to bear risk Risk-Free Investing ER p RF + w (ER ARF) where ER is phe expected return on the portfolio that starts out with w = 0 as w increases, more is placed in the risky portfolio, so the investor picks up ER at the cost of taking money out of T-bill p p= [(w) ( A + (1 w) ( RF+ 2 (1 w) (w) ( A, RF(A) (RF)] = [(w) (A ) ] = w A ER p RF + [(ER ARF) ]A p tangent portfolio the risky portfolio on the efficient frontier whose tangent line cuts the vertical axis at the risk-free rate new (or super) efficient frontier portfolios composed of the risk-free rate and the tangent portfolio that offer the highest expected rate of return for any given level of risk Risk-Free Borrowing short position negative position in asset; investor achieves it by borrowing part of assets purchase price from stockbroker of course, investors must pay interest on the borrowed money, which can be assumed to be at the risk-free rate The New Efficient Set and the Separation Theorem separation theorem the theory that the investment decision (how to construct the portfolio of risky assets) is separate from the financing decision (how much should be invested or borrowed at the risk-free rate) market portfolio a portfolio that contains all risky securities in the market in theory, market portfolio should contain all risky assets, including stocks, bonds, options, futures, gold, real estate, and s

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