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Return
Income of investment
Stages of EMH
Weak-form market efficiency Historical information Semi strong-form market efficiency Not based on Publicly available information Strong-form market efficiency Publicly available and private information (insiders)
4
100
100
2
5
Security Portfolios
Expected return for a portfolio is a weighted average of expected returns for securities in the m portfolio
rp =
r A
j j =1
Where m is number of securities, rj is return on security j and Aj is proportion of total funds invested in security j (probability) Portfolio risk is the total risk involved in a portfolio of securities. - Depends on riskiness of securities as well as their relation (little relationship between securities).
6
Covariance Measures how closely returns move together jk= rjk j k rjk is the expected correlation between security j and k
j is the standard deviation of security j k is the standard deviation of security j
Range of correlation
-1 to +1
r=
Pj Pk jk
j=1 k=1
Double summation sign means that we will sum all the variances and co variances in the matrix of all possible pair wise securities
Portfolio 1 2 3 4 5 6
10
11
12
CAPM Assumptions
Capital markets are highly efficient Investors are well informed Zero transaction costs Negligible restrictions on investment No taxes No investor can affect market price Common holding period is 1 year
13
Alpha < 0: rational investor will avoid investing in stock and will invest in risk free security or will prefer portfolio investing. = 0 The investment has earned a return adequate for the risk taken > 0 the investment has a return in excess of the reward for the assumed risk and characteristic line will move upward.
15
Beta
A measure of volatility or risk Beta = 1 (security price will move with the market) Beta> 1 (security price will be more volatile than market) Beta< 1 (security price will be less volatile than market)
16
SML
Eq. risk premium
Rm
Rf Rt
Risk free return
18
ERP= Rm-Rf
ERP is greater when interest rate (k) is lower ERP is lesser when interest rate (k) is higher
19
P is market price per share Dt is expected dividend at time t K is investors required rate of return=Rt Greater Rt/K lower will be the stock price
20