Chapter 18 CAPITAL ASSET PRICING THEORY What is

Chapter 18 CAPITAL ASSET PRICING THEORY • What is the capital market line (CML)? • How is the Capital Asset Pricing Model (CAPM) developed? • What is the difference between the standard deviation risk and beta risk measures? • How can an investor apply the CAPM to security analysis? • How do you estimate beta? • What are the good news and the bad news about beta?

Assumptions of the Capital Asset Pricing Model • Investors have homogeneous expectations • Frictionless capital markets • Investors are rational and seek to maximize their expected utility functions • Investment is for one-period only • All investors can borrow or lend at the riskfree rate

Efficient frontier and the optimal risky portfolio • Developing the capital market line (CML) – Introducing the riskfree asset. – The capital market line (CML) or the borrowing-lending line. – The Portfolio Separation Theorem – The market portfolio, M

Figure 18. 1 – Efficient Frontier

Figure 18. 2 – Efficient Frontier and Utility Curves for Investors A and B

Figure 18. 3 – Combinations of the Risk-Free Asset RF and Risky Portfolios P 1 and P 2

Figure 18. 4 – Combinations of the Risk-Free Asset RF and the Risky Portfolio M

Figure 18. 5 – CML and Individual Utility Curves

Figure 18. 6 – CML: The Borrowing-Lending Line

Capital Asset Pricing Model • Developing a relative risk measure • Understanding beta – Systematic risk or market risk – Diversifiable risk or firm-specific risk

Figure 18. 7 – CML and Individual Securities

CAPM derivation • Security risk and return – Reward for investing in a security – Security risk – Security’s reward-to-risk ratio – Risk/return relationship – The security market line (SML) • Differences between the CML and SML

Figure 18. 8 – Security Market Line (SML)

CAPM and security analysis • Estimating the required return. • Estimating the predicted return. • Security analysis decision rule. • Comparison with fundamental analysis.

Estimating Beta • Security characteristic line • Information service beta estimates • Calculating beta: Separating systematic risk from diversifiable risk. • Differences between the SML and the security characteristic line

Good news and bad news about Beta • How reliable are beta estimates? • Does beta really measure risk? • The verdict on beta. • Implications for investors

Figure 18. 9 – Security Market Line Analysis

Figure 18. 10 – Regression Analysis to Estimate Beta