Finance School of management Intuitive of capm All the investors will allocate their investments between the riskless asset and the same tangent portfolio In equilibrium, the aggregate demand for each security is equal to its supply The only way the asset market can clear is if the relative proportions of risky assets in tangent portfolio are the proportions in which they are valued in the market place, i. e. the market portfolio uesTc
6 Finance School of Management Intuitive of CAPM u All the investors will allocate their investments between the riskless asset and the same tangent portfolio u In equilibrium, the aggregate demand for each security is equal to its supply u The only way the asset market can clear is if the relative proportions of risky assets in tangent portfolio are the proportions in which they are valued in the market place, i.e. the market portfolio
Finance School of management The Capital Market Line(CML) CML Expected Return (%) M E(rm)-re Standard Deviation o uesTc
7 Finance School of Management The Capital Market Line (CML) Standard Deviation s Expected Return (%) CML rf M E(rM)- rf sM
Finance School of management Efficient risk-reward LE(M)-rfI E(r=r+ u In equilibrium, any efficient portfolio should be a combination of the market portfolio and the riskless asset u The best risk-reward depends on how much the market-related a portfolio bears uesTc
8 Finance School of Management Efficient Risk-reward s s M M f f E r r E r r [ ( ) ] ( ) − = + u In equilibrium, any efficient portfolio should be a combination of the market portfolio and the riskless asset u The best risk-reward depends on how much the market-related a portfolio bears
Finance School of management Determining the risk Premium on the Market portfolio The equilibrium risk premium on the market portfolio is the product of variance of the market weighted average of the degree of risk aversion of holders of risk. A E(M-r=AoM uesTc
9 Finance School of Management Determining the Risk Premium on the Market Portfolio u The equilibrium risk premium on the market portfolio is the product of – variance of the market, s2 M – weighted average of the degree of risk aversion of holders of risk, A 2 ( ) M f A M E r −r = s
Finance School of management Example: To Determine A E(M)=0.14,M=0.20,7=006 E(r)-r=Aa→sb(m)-r 2 M 0.14-0.06 2.0 0.202 uesTc 10
10 Finance School of Management Example: To Determine ‘A’ 2.0 0.20 0.14 0.06 ( ) ( ) ( ) 0.14, 0.20, 0.06, 2 2 2 = − = − − = = = = = A E r r E r r A A E r r M M f M f M M M f s s s