11-03-2014, 03:58 PM
CAPITAL ASSET PRICING MODEL
CAPITAL ASSET PRICING.ppt (Size: 165.5 KB / Downloads: 17)
INTRODUCTION
The Capital Asset Pricing Model (CAPM) is a model developed in an attempt to explain variation in yield rates on various types of investments
CAPM is based on the idea that investors demand additional expected return (called the risk premium) if they are asked to accept additional risk
The CAPM model says that this expected return that these investors would demand is equal to the rate on a risk-free security plus a risk premium
DIVERSIFICATION
A risk management technique that mixes a wide variety of investments within a portfolio
The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio
This only works for unsystematic risks
ASSUMPTIONS
The Capital Asset Pricing Model is a ceteris paribus model. It is only valid within a special set of assumptions:
Investors are risk averse individuals who maximize the expected utility of their end of period wealth
Investors have homogenous expectations (beliefs) about asset returns
Asset returns are distributed by the normal distribution
There exists a risk free asset and investors may borrow or lend unlimited amounts of this asset at a constant rate: the risk free rate
CAPM: Derivation
Step 1. The derivation of the CAP-model starts by assuming that all assets are stochastic and follow a normal distribution. This distribution is described completely by its two parameters: mean value (m) and variance (s2). The mean value is a measure of location among many such as median and mode. Likewise, the variance value is a measure of dispersion among many such as range, semiinterquartile range, semivariance, mean absolute deviation. In the hypothetical world of the CAPM theory all that the investor bothers about is the values of the normal distribution. In the real world asset return are not normally distributed and investors do find other measures of location and dispersion relevant. However, the assumption may be seen as a reasonable approximation and it is needed in order to simplify matters.