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Capital Market Theory (Chap 9,10 of RWJ)

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Capital Market Theory (Chap 9,10 of RWJ). 2003,10,16. Returns. Dollar returns: terminal market value – initial market value Percentage returns=dollars returns/initial market value Dividend yield=dividend at end of period / present price Capital gain= price change of stock / initial price

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returns
Returns
  • Dollar returns: terminal market value – initial market value
  • Percentage returns=dollars returns/initial market value
  • Dividend yield=dividend at end of period / present price
  • Capital gain= price change of stock / initial price
  • Total returns= dividend yield + capital gains
holding period returns
Holding period returns
  • (1+R1)(1+R2)…(1+RT) for T years
  • Small-company
  • Large-company
  • Long-term government bonds
  • Treasury bill
  • inflation
average stock return and risk free return
Average stock return and risk-free return
  • Risk-free return:
  • Risk premium = excess return on the risky asset = risky asset return – risk-free return
  • Risky returns as a normal distribution
slide5
Expected return
  • Variance
  • Covariance
  • Correlation
  • Expected return of a portfolio is the weighted sum of individual expected return.
diversification effect
Diversification effect
  • As long as correlation <1, the standard deviation of a portfolio of two securities is less than the weighted average of the standard deviations of the individual securities.
  • Extend to more securities.
efficient set efficient frontier for two assets
Efficient set (efficient frontier) for two assets
  • Minimize variance of portfolio for constant expected mean.
limit of reduced variance
Limit of reduced variance
  • Portfolio who contains all assets.
  • Variance as “ risk”.
  • Total risk of individual security = portfolio risk (systematic risk) + diversifiable risk (or unsystematic risk)
market equilibrium
Market equilibrium
  • In a world of homogeneous expectations, all investors would hold the portfolio of risky assets
  • Market portfolio: market-value-weighted portfolio of all existing portfolio.
slide10
Beta
  • Beta measures the responsiveness of a security to movements in the market portfolio
  • Beta_i=Cov(R_i,R_M)/Sigma^2(R_M)
relation between risk and expected return capm
Relation between risk and expected return (CAPM)
  • R_M=R_F+ Risk premium
  • R=R_F+Beta(R_M-R_F)
  • Beta=0: riskless asset
  • Beta=1: Market portfolio
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