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Sharpe Lintners model

Capital Asset Pricing Model - CAPM

William Sharpe (1963, 1964) and John V.


Lintner (1965)
Risk free asset with return r f ;
Market portfolio consists of all risky assets
on the market;
Every rational investor chooses some linear
combination of market portfolio and risk
free asset, according to his risk preferences;
Model explains an investment's return above
risk free rate only by its covariance with the
market (presented with market portfolio).
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Assumptions

All investors are looking for M-V efficiency;


Homogeneous market expectations;
Identical set of constraints;
Number of investors is large enough, so there
is no individual influence on the prices of
investments (standardized securities like stocks
and bonds and risk free asset);
No transaction costs and taxes.

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Market portfolio

x1M
M
x2
M :

:
x n
M

where
Vi
x iM n

V
i 1
i ,

Vi market value of the ith risky asset, so


x iM is the ratio between value oft he ith asset
and value of all investments on the market.
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Market portfolio

It follows that market portfolio consists of all


risky assets on the market. All shares appear in
it with positive proportions, according their
market value.
Real market portfolio?
Usually, market indices are taken as market
portfolios surrogates.

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Risk free asset

Risk free asset can be defined as


investment which expected return
probability equals 1.
Ussually, short term government bond
and/or treasury bill is taken as risk free
asset and it's return as risk free return.

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Combination of the market portfolio and risk
free asset

Now consider a combination portfolio of the


market portfolio M and the risk-free asset; suppose that
the weight of the risk-free asset in such a portfolio is a.
Then the portfolio's expected return and standard
deviation are given by:

E( R ) ar f (1 a) E( RM ) ,

a 2 rf2 (1 a) 2 M
2
2a(1 a)Cov(r f , M ) (1 a) M .

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Capital Market Line - CML

The locus of all such combinations for


a 0 is known as the capital market
line (CML). It appears along with the
efficient frontier int he following graph.

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Capital Market Line - CML

E R CML

M
rf trini portfelj

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Security Market Line - SML and Beta

If all investors agree about the statistical


assumptions of the model the variance-
covariance matrix S and the vector of expected
asset returns R and if a risk-free asset exists,
then individual asset returns are defined by the
security market line (SML):


E ( Ri ) rf i E ( RM ) rf ,

where the asset's beta is given by

Cov( Ri , RM )
i
M2 .
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SML Security Market Line

E R SML

M
E RM
rf

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Beta

Beta is the measure of the systematic risk which cannot


be avoided by diversification.
It shows sensitivity of the security's rate of return on
change of market portfolio's return.
It represents the measure of risk for securities in well
diversified portfolio (like market portfolio).

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Beta

1) 1 , return rises or falls like market portfolio's


return;
2) 1 , return rises or falls more than market portfolio's
return, risky asset;
3) 1 , return rises or falls less than market portfolio's
return;
4) 0 , security's return is inverse to market portfolio's
return.

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Portfolios Beta

n

i 1
i i
.

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