1726 words - 7 pages

Financial Management- IICase NotesRPL and MRPL - Analyzing Risk and ReturnSubmitted By- Sumer Lal MeenaExe-PGP 2007-09Background ReadingThe Capital Asset Pricing Model (CAPM)Some, but not all, of the risk associated with a risky investment can be eliminated by diversification. The reason is that unsystematic risks, which are unique to individual assets, tend to wash out in a large portfolio, but systematic risks, which affect all of the assets in a portfolio to some extent, do not.Because unsystematic risk can be freely eliminated by diversification, the systematic risk principle states that the reward for bearing risk depends only on the level of systematic risk. The level of systematic risk in a particular asset, relative to average, is given by the beta of that asset.The reward-to-risk ratio for Asset i is the ratio of its risk premium, E(Ri) - Rf, to its beta, Bi: [E(Ri) - Rf]/BiIn a well-functioning market, this ratio is the same for every asset. As a result, when asset expected returns are plotted against asset betas, all assets plot on the same straight line, called the security market line (SML).From the SML, the expected return on Asset i can be written: E(Ri) = Rf +Bi[E(Rm) - Rf]This is the capital asset pricing model (CAPM). The expected return on a risky asset thus has three components. The first is the pure time value of money (Rf), the second is the market risk premium, [E(Rm) - Rf], and the third is the beta for that asset, Bi.The CAPM implies that the risk premium on any individual asset or portfolio is the product of the risk premium of the market portfolio and the asset's beta.The CAPM assumes investors are rational single-period planners who agree on a common input list from security analysis and seek mean-variance optimal portfolios.The CAPM assumes ideal security markets in the sense that: (a) markets are large, and investors are price takers, (b) there are no taxes or transaction costs, (c) all risky assets are publicly traded, and (d) any amount can be borrowed and lent at a fixed, risk-free rate. These assumptions mean that all investors will hold identical risky portfolios.The CAPM implies that, in equilibrium, the market portfolio is the unique mean-variance efficient tangency portfolio, which indicates that a passive strategy is efficient.The market portfolio is a value-weighted portfolio. Each security is held in a proportion equal to its market value divided by the total market value of all securities. The risk premium on the market portfolio is. proportional to its variance and to the risk aversion of the average investor.In a single-index security market, once an index is specified, any security beta can be estimated from a regression of the security's excess return on the index's excess return.This regression line is called the security characteristic line (SCL). The intercept of the SCL, called alpha, represents the average excess return on the security when the index excess return is zero. The CAPM implies that...

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