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FIN 614: Financial Management Larry Schrenk, Instructor 1. Capital Market Line (CML) 2. Security Market Line (SML) 3. Capital Asset Pricing Model (CAPM) Return Market Portfolio rf Efficient Frontier CML MVP sp Security Market Line (SML) Graphing the relationship between beta and return Begin with the two points we know: Market Risk Free Asset Return rM rf Beta 1 0 Return We know two points. Where would we find portfolios that contain combinations of the risk free asset and the market? rM Market rf Risk Free Asset 0 1 Beta SML Return What would happen if there were a stock above the line? Market equilibrium forces all stocks to be on the line, which is called the Security Market Line (SML). rM What would happen if there were a stock below the line? rf 0 1 Beta CAPM Equation Formula for the SML E ri rf i rM rf E ri = Expected Return on Stock i; rf = Risk-Free Rate βi = Beta of Stock i; rM = Return on the Market Firm Data Beta Market Data The Risk Free Rate The Return on the Market It is the equilibrium model that underlies all modern financial theory. Derived using principles of diversification with simplified assumptions. Markowitz, Sharpe, Lintner and Mossin are researchers credited with its development. Single-period investment horizon. Investors forecasts agree with respect to expectations, standard deviations, and correlations of the returns of risky securities Therefore all investors hold risky assets in the same relative proportions Investors behave optimally In equilibrium, prices adjust so that aggregate demand for each security is equal to its supply Beta Linear Regression Firm Stock Return on Market Return (S&P 500) Risk Free Rate Treasury Security Maturity = CAPM Time Horizon Return on the Market Average Return on a Market Portfolio (S&P 500) Use the following, to find the expected return: rf = 4.5% rM = 12.3% Find the expected return on the following three stocks: • A = 1.02 • B = 0.89 • C = 1.34 E ri rf i rM rf E rA 0.045 1.02 0.123 0.045 12.46% E rB 0.045 0.89 0.123 0.045 11.44% E rC 0.045 1.34 0.123 0.045 14.95% FIN 614: Financial Management Larry Schrenk, Instructor