5. Resulting Equilibrium
Conditions
โข All investors will hold the same portfolio
for risky assets โ market portfolio
โข Market portfolio contains all securities
and the proportion of each security is its
market value as a percentage of total
market value
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10. โข Determine the equation of the SML and plot it
when:
( E (r
M ) โ rf ) = 0.08
and
rf = 0.03
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11. Application
โข You are in an economy where Rf=9%,
E(Rm)=20%.
โข Determine the equation of the SML line in
this economy.
โข A stock has a beta=1.5. Determine the
required rate of return. Give your
recommendation when you think its
expected return will be 22%.
โข Do the same analysis when beta=-0.5 and
investor expect the return to be 7% 11
12. Estimating the Index Model
โข Using historical data on T-bills, S&P 500
and individual securities
โข Regress risk premiums for individual
stocks against the risk premiums for the
S&P 500
โข Slope is the beta for the individual stock
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16. โข Limitations for CAPM
โข Market Portfolio is not directly observable
โข Research shows that other factors affect
returns
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17. Fama French Research
โข Returns are related to factors other than market
returns
โข Size
โข Book value relative to market value
โข Three factor model better describes returns
โข Example : GM
E (rGM ) โ r f = ฮฒ GM , M ( E (rM ) โ rf ) + ฮฒ GM ,SMB ( E (rSMB ) โ rf ) + ฮฒ GM , HML ( E (rHML ) โ rf )
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20. โข Arbitrage - arises if an investor can
construct a zero beta investment portfolio
with a return greater than the risk-free rate
โข If two portfolios are mispriced, the investor
could buy the low-priced portfolio and sell
the high-priced portfolio
โข In efficient markets, profitable arbitrage
opportunities will quickly disappear
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21. Security
Line Characteristics
E (rP ) โ rf = ฮฒ P ( E (rM ) โ rf )
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22. APT and CAPM Compared
โข APT applies to well diversified portfolios and not
necessarily to individual stocks
โข With APT it is possible for some individual stocks
to be mispriced - not lie on the SML
โข APT is more general in that it gets to an
expected return and beta relationship without the
assumption of the market portfolio
โข APT can be extended to multifactor models
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