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  1. 1. Chapter 2. Equity Market: Capital Asset Pricing Model The Oxford Guide to Financial Modeling Thomas S. Y. Ho and Sang Bin Lee Copyright © 2004 by Thomas Ho and Sang Bin Lee. All rights reserved.
  2. 2. 2.1 Real and Financial Sectors <ul><li>Tangible assets, commodities </li></ul><ul><ul><li>metals, buildings, factories, inventories, </li></ul></ul><ul><li>Intangible assets </li></ul><ul><ul><li>patents, branding </li></ul></ul><ul><li>Financial securities </li></ul><ul><ul><li>Stocks, bonds, options, mortgages </li></ul></ul><ul><li>Role of a corporation </li></ul><ul><ul><li>Economic units </li></ul></ul><ul><ul><li>Organization of a corporation </li></ul></ul>
  3. 3. 2.2 Stocks and Stock Market <ul><li>Dividends, capital gains </li></ul><ul><ul><li>Announcement date, ex-dividends </li></ul></ul><ul><li>Types of orders </li></ul><ul><ul><li>Market orders: immediate execution at the market price </li></ul></ul><ul><ul><li>Limit orders: wait for the execution at the stated price </li></ul></ul><ul><li>Factors affecting the bid ask spreads </li></ul><ul><ul><li>Market makers, competition, trading volume </li></ul></ul>
  4. 4. Spot Market <ul><li>Primary market </li></ul><ul><ul><li>new issuance </li></ul></ul><ul><ul><li>Investment banking </li></ul></ul><ul><li>Secondary market: </li></ul><ul><ul><li>Exchanges: central location, specialists </li></ul></ul><ul><ul><li>Over-the-counter </li></ul></ul><ul><ul><ul><li>Open limit order book </li></ul></ul></ul><ul><ul><ul><li>Market makers </li></ul></ul></ul><ul><li>Electronic Communication Network (ECN) </li></ul>
  5. 5. Future and Forward Markets <ul><li>Forward contracts </li></ul><ul><li>Futures contracts </li></ul><ul><li>Counter-parties </li></ul><ul><li>Open interests </li></ul><ul><li>Marking to market </li></ul><ul><li>Indices: S&P 500, Nikkei 225 </li></ul>
  6. 6. 2.3 Perfect Capital Market <ul><li>All financial claims are perfectly divisible </li></ul><ul><li>No transaction costs </li></ul><ul><li>No taxes </li></ul><ul><li>Competitive markets </li></ul><ul><li>No limit in short selling </li></ul><ul><li>Information symmetry </li></ul><ul><li>Increasing utility of wealth and risk aversion </li></ul>
  7. 7. 2.4 Efficient Capital Market Hypothesis <ul><li>Weak form efficiency </li></ul><ul><li>Semi-strong form efficiency </li></ul><ul><li>Strong form efficiency </li></ul>
  8. 8. 2.4 Efficient Capital Market Hypothesis
  9. 9. 2.5 Diversification <ul><li>A portfolio in general reduces the risk of an individual stock </li></ul><ul><li>Contribution of risk from each stock </li></ul><ul><li>A measure of risk: standard deviation </li></ul><ul><li>The example of 2 coins shows that the standard deviation is lowered in betting on 2 coins than putting all the bet on one coin </li></ul>
  10. 10. Diversification (an Example)   Head/Head Head/Tail Tail/Tail Probability 0.25 0.5 0.25 Outcomes $200 $100 0
  11. 11. Lognormal and normal distributions with a mean and a standard deviation -1.96 0 1.96 0.1 0.2 0.3 0.4 Normal Density 0.23 11.7 0.1 0.2 0.3 0.4 Lognormal Density
  12. 12. Diversification Effect Systematic Total 10 20 30 40 0.03 0.04 0.05 0.06 0.07 10 20 30 40 The number of stocks 0.03 0.04 0.05 0.06 0.07 Risk % Systematic Risk Total Risk
  13. 13. Diversification Effect the average risk of portfolios :
  14. 14. Diversification Effect
  15. 15. Capital Asset Pricing Model
  16. 16. Capital Market Line CML A B C M 0 E D
  17. 17. the variance of the market portfolio
  18. 18. 2.7 Beta – the Systematic Risk
  19. 19. Security Market Line: relationship between expected return and beta
  20. 20. The Constant Growth Stock Model <ul><li>S the stock price </li></ul><ul><li>D the dividends </li></ul><ul><li>The required return of the stock </li></ul><ul><li>The constant growth rate </li></ul>
  21. 21. 2.8 The Dividend Discount Model
  22. 22. 2.10 Empirical Tests of the Capital Asset Pricing Model <ul><li>Black, Jensen, Scholes (1972) </li></ul><ul><li>Fama and Macbeth (1974) </li></ul><ul><ul><li>Relate the stock betas with the long term stock returns </li></ul></ul><ul><li>Roll (1977) </li></ul><ul><ul><li>Is CAPM testable? </li></ul></ul><ul><li>Stambaugh(1982) </li></ul><ul><ul><li>What is the market portfolio? </li></ul></ul>