Week3Notes FIN 500
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This 2 page Class Notes was uploaded by D S on Friday September 25, 2015. The Class Notes belongs to FIN 500 at University of Illinois at Urbana-Champaign taught by Adam Clark-Joseph in Summer 2015. Since its upload, it has received 37 views. For similar materials see Introduction to Finance in Finance at University of Illinois at Urbana-Champaign.
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Date Created: 09/25/15
Introduction to Fiance Week 3 Professor ClarkJoseph University of Illinois Urbana Champaign September 25 2015 1 CAPM Lecture Notes CAPM asset pricing model and is dervied directly from mean variance analysis and states that expected returns of a risky asset depends only upon the covariance of the market CAPM rf 620 rf TM 2 return on market portfolio 6 m covnrM 0i varrM market portfolio is a value weighted portfolio of all assets ie weight wj wj everything in the world Economic Meaning Basically tells us what each asset s risk premium should be holding covariancess xed in this equilibrium state What is this equilibrium state state mean idea is we can nd ef cient fund of risky assets wo computing return of asset by assuming others wil solve MV with own common estimates and their orders will stabalize price until demand matches supply covariances likely re ect real economic characters WHAT Coca Cola and Pepsi if one has signi cant expected return then the price will change and thus want right return concept of equilibrium current prices expected return depends on current price Derivation intuition market portfolio is MV ef cient and utilizig the MV ef cient portfolio formulas express risk premium on an asset is proportional to the risk premium on the market portfolio where the coef ent 6 of the asset What was the point looking at the betas Beta of the portfolio is incredible useful since its the only parameter that needs to be known about the asset s isk characteristics to use the CAPM formula aggressive companies or highly leveraged companies should have higher betas compared with conservative and companies who are not related to teh market behavior also similar businesses like Exxon and Standard Oil should have similar betas as well Beta of a portfolio TP 2 2 win which means that 6P 2 2 20262 Security Market Line rf 6207 rf formula expressing the expected return of a security as a funcion of a covariances value all shares of asset j total value of all assets shows the linear variation of 7 under the equilibrium conditions assumed by the CAPM any asset should fall on the security market line Capital Market Line another straight line Tf is the y intercept relation between standard I A J Tf 0 M deviation and expected return 7 Tf 0p applies to MV ef cient portfolio we did it in HWl Performance Evaluation we don t live in a perfect world what if the CAPM incorrectly predicts return 7 Tf oz 677 4 rf oz difference between teh expected return on the stock and the expected rturn predicted by the CAPM another name Jensen s Alpha oz gt 0 then stock will blot above the SML hold oz lt 0 then stock will blot below the SML short What is this market model 71 2 oz rm I 6 interest rate derivates but it uses the forward rate and one factor one source of volatility 5 min simpli ed HJ M basically uses forward rates which are actively traded so easier to calibrate return on a security depends on the return on the market portfolio and the extent of the security s responsiveness as measured by beta The return also depends on conditions that are unique to the rm The market model can be graphed as a line tted to a plot of asset returns against returns on the market portfolio This relationship is sometimes called the single index model somehow got to 02 303 vare full derivation found using euler s decomposition 6203 systematic market risk vare idiosyncratic risk and not located in the formula for expected returns Argument was that only n variance terms and n2 n covariane terms so for a large portfolio only the covariance terms dominate the sum so all stocks in Europe will have lowest idiosyncratic risk Followed up on testing the CAPM theory Lookd at Multifactor models speci cally Fama French Model which model of returns on common stocks using 7 Tf 6rm rf 8SMB 5 7 M Tf excess return on the market portfolio SM B rsma11big H M L Thigh now 2 Sides comments Mandelbrot stable distribution like Gaussian if you add up alot of X stable the you still get a Gaussian distribtion back talked about combining different parameters and decided that not all parameters combine as neicely as Guassian 3 Fund spanning idea special case of 2 alpha beta 1 alpha beta Shorting for risky assets must be positive borrowing lending net is important risk netural and borrow restrained only pick asset highest rate of return weight
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