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Capital Market Theory (Chap 9,10 of RWJ)PowerPoint Presentation

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
- Total returns= dividend yield + capital gains

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

- Risk-free return:
- Risk premium = excess return on the risky asset = risky asset return – risk-free return
- Risky returns as a normal distribution

- Expected return
- Variance
- Covariance
- Correlation
- Expected return of a portfolio is the weighted sum of individual expected return.

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

- Minimize variance of portfolio for constant expected mean.

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

- 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.

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)

- 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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