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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### 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)