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Capital Market Theory (Chap 9,10 of RWJ)

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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Capital Market Theory (Chap 9,10 of RWJ)

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  1. Capital Market Theory(Chap 9,10 of RWJ) 2003,10,16

  2. 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

  3. Holding period returns • (1+R1)(1+R2)…(1+RT) for T years • Small-company • Large-company • Long-term government bonds • Treasury bill • inflation

  4. 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

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

  6. 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.

  7. Efficient set (efficient frontier) for two assets • Minimize variance of portfolio for constant expected mean.

  8. 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)

  9. 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.

  10. 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)

  11. 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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