FINS2624 Lecture Notes - Lecture 4: Idiosyncrasy, Capital Asset Pricing Model, Systematic Risk
Kristy
1
CAPM notes
- Price and return inverse relationship- higher risk = higher required return, expected return
- Of portfolio M:
- Asset j’s otriutio to arket portfolio Erm) is wjE(rj) + contrib to var = wjCov(rj,rm)
- Positive relo between E(r) and Cov(r(j),r(M))- ore otriutio to M’s risk = higher Er
- Risk free asset does’t otriute to risk ut arries retur rf
o Relate E(rj) – rf and Cov(rj,rM) – Cov(rf,rM) = Cov(rj,rM)
o
o a asset j’s Er i eess of rf risk preiu = risk*prie of risk
o risk is measured by relative contribution to variance of market portfolio ßj
o market portfolio ß=1, risk free asset ß=0 E(rf) = rf
- security market line (SML)- each asset j is compensated w excess return in relation to its risk in the
market portfolio (E(r) - ß)
- risk ratio in CAPM ß=cov(ri,rM)/var(M)- on a line, not E(r) – rf
- ßi > 1 means cov(ri,rM) > var(rM) (contribution of asset j risk to portfolio risk)
- ßi < 1 means cov(ri,rM) < var(rM)
- CAPM ol tells us relatioship etwee a asset’s epeted eess return E(rj) – rf = ßj*(E(rM) –
rf)
o The realised returns of the asset and M may deviate from E(r)- CAPM may not hold for
realised returns- stochastic
o
o
- ß term is market risk, epsilon term is
idiosyncratic risk (diversifiable) (epsilon uncorrelated to rM)
o CAPM states that only systematic risk is priced
o CAL relates E(r) to total risk measure (volatility) for efficient portfolios
i. Total risk = systematic risk only
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Kristy
2
A’s risk right is ussteati: added risk ut o etra retur
- On CAL, all idiosyncratic risks are diversified away (total risk = systematic)
- SML: relate E(r) to systematic risk - ßj
all A plot on SML quod ß is priced w E(r)
2. P beta = weighted avg of beta assets
3. ß(M) = 1
4. CAPM: avoid unsystematic risk by holding a well-diversified portfolio; relate returns to return
benchmark (w similar systematic risk), examine whether unexpected component of realised
return is due to idiosyncratic risk of investment; capital budgeting (ß, PV of CF, required returns,
NPV)
Non assessment
5. Assumptions of CAPM: rational mean-var optimiser investors (maximise utility function correctly)
6. Investors are price takers- no investor is large enough relative to market to influence equilibrium
by trades
7. Investors have identical investment horizons and agree on statistical properties of all A (E(r) and
covariance)
o Above assumptions ensure maximise utility
8. Risk free asset is available to all- all investors can borrow and invest at same rate
9. All investors can trade all assets
o Above assets ensure every investor finds P* (tangent optimal P)- since everyone holds P*,it
is the market portfolio of ALL risky assets
10. PCM (M&M) no financial frictions
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