Summary Risk return and Capital Asset pricing Model
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Course
Finance (BT1209)
Institution
Erasmus Universiteit Rotterdam (EUR)
This summary helps understand and explain how the riskiness of an individual stock is measured and translated into a required return, as illustrated by the Capital Asset Pricing Model (CAPM). Then, it explains the differences and similarities between the Capital Market Line (CML) and Security Marke...
Finance
Risk-return and the Capital Asset Pricing Model
I. Portfolio theory
A. Identifiy effeicent portfolios (PF)
II. CAPM & assumptions
A. All equity firms
B. Introducing leverage
C. Introducing more sorts of debt
III. Putting everything together
A. What do we use the WACC for ?
IV. CAPM applications
A. Measuring betas and returns
B. Finding betas
C. 3 Determinants of the CAPM beta
V. Choosing the optimal capital structure
VI. The WACC fallacy
, Portfolio theory
Ef cient frontier represents the maximum return R you may obtain with a PF of multiple assets
given the riskiness (STDEV) of every combination of assets you may hold
The tangent is called ef cient PF --> has the highest Sharpe ratio :
On the CML: everything between the risk-free asset (y-axis) and the tangent = lending --> after =
borrowing
The Capital Market Line only exists for mean-variance ef cient portfolios
Identify ef cient portfolio:
A priori know the expected returns, volatilities, and correlations between all stocks
IMPOSSIBLE forecast => Capital Asset Pricing Model: in order to put PF theory into practice
CAPM is used to price the riskiness of an individual stock by calculating the return investors
demand on a risky asset
ASSUMPTIONS :
All securities have :
constant variance & covariance
Equally weighted in the PF
The variance of a PF drops as more securities are added to the PF
BUT does not drop to zero --> oor = COV
The riskiness of any stock has 2 components:
Idiosyncratic: rm-speci c --> can be diversi ed away (upper part of the graph above COV)
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