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    Solution Manual For Essentials of Investments 11th by Bodie

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    Solution Manual For Essentials of Investments 11th by Bodie

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    173 views5 pages

    Solution Manual For Essentials of Investments 11th by Bodie

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    AlisonHillqczf
    Solutions Manual

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    © All Rights Reserved
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    Solution Manual for Essentials of Investments 11th by Bodie

    Solution Manual for Essentials of Investments 11th


    by Bodie

    To download the complete and accurate content document, go to:


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    -by-bodie/

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    Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

    CHAPTER SEVEN
    CAPITAL ASSET PRICING AND ARBITRAGE PRICING
    THEORY
    CHAPTER OVERVIEW
    This chapter first presents the capital asset pricing model (CAPM), an equilibrium pricing model
    derived from a set of fairly restrictive assumptions delineated in the PPT. This model was
    instrumental in the development of modern finance theory and several of its developers won the
    Nobel Prize for Economics. The essential feature of the CAPM is that the portfolio tangent to the
    Capital Market Line (CML) is the market portfolio of all risky assets. The chapter also presents
    an empirical model, the well known Fama-French 3 factor model. Finally, the chapter discusses
    the arbitrage pricing theory (APT).

    LEARNING OBJECTIVES
    After studying this chapter, the student should understand the concept and usage of the capital
    asset pricing model (CAPM). Similarly the reader should to be able to construct and use the
    Security Market Line. The student should also have a basic understanding of index models and
    the Fama-French model. Readers should also understand the arbitrage pricing theory (APT) and
    to be able to use this theory to identify mispriced securities. The student should also understand
    the similarities and differences between the two main theories and the limitations of each.

    CHAPTER OUTLINE
    1. The Capital Asset Pricing Model
    PPT 7-2 through PPT 7-12
    The introduction of the CAPM starts with an overview of the importance of the model and the
    assumptions that underlie it. The implications or conditions that will result from the CAPM are
    provided. Once the major implications and conditions have been discussed, the Capital Market
    Line can be examined. In discussing the CML, it is important to stress that any complete
    portfolio on the CML will dominate all portfolios on the efficient frontier (other than the
    tangency portfolio).

    The resulting conclusion is that investors, regardless of their risk preferences, will combine the
    market portfolio with the risk-free investment. Since the equilibrium conditions result in all
    investors holding the same portfolio of risky investments, pricing of individual securities is
    related to the risk that individual securities have when they are included in the market portfolio.
    The relevant measure of risk is the covariance of returns on the individual securities with the
    market portfolio.

    Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
    of McGraw-Hill Education.
    Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

    The Security Market Line (SML) graphically depicts the market price of risk. The beta for the
    individual security is the [Cov (ri,rm)]/Var rm. The beta is the measure of the amount of
    systematic risk a stock has, or equivalently the amount of risk a stock will have when it is put
    into a well diversified portfolio. Thus, the product of the market wide price of risk (rm – rf) / m
    times i is the premium for bearing risk; and the required return for a security that compensates
    for its systematic risk is risk premium (described above) plus the risk-free rate. The SML can
    also be used to illustrate a security’s alpha. Portfolio betas are simple weighted averages of the
    component security betas and are easy to calculate.

    Expected Returns on Individual Securities will be governed by the following relationship:

    2. The CAPM and Index Models


    PPT 7-13 through PPT 7-16
    Development of an index model and an example security characteristic line (SCL) are provided.
    Using regression analysis and the risk premiums for individual stocks, the slope of the
    relationship is the beta for an individual stock.

    Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
    of McGraw-Hill Education.
    Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

    In the PPT the concept of adjusted betas is presented. The depth in which you choose to cover
    this topic should depend on the background of your students. You may wish to spend some time
    in class developing confidence intervals and discussing the notion of statistical significance. The
    significance of the alpha and beta measures is an important item to be discussed in class if the
    student’s preparation in statistics is adequate.

    3. CAPM and the Real World


    PPT 7-17
    This brief section gives some background about some of the main conclusions that can be drawn
    from studies of the real world applicability of the CAPM. Although the model cannot be directly
    tested (remember Roll’s critique) the practicality of the CAPM as it applied can and has been
    extensively tested. The main conclusion of these tests is that there may be better measures of the
    risk premium than the estimates we use following the CAPM.

    This is the motivation for the Fama-French model described in the next section. As an aside, we
    can conclude that the CAPM is false based on the validity of its assumptions. Nevertheless the
    concepts from the CAPM remain valid and very important -- in particular, investors should
    diversify; only systematic risk matters; and a well-diversified portfolio can be suitable to a wide
    range of investors with different risk tolerances.

    A broker or planner will still wish to identify the best-performing set of risky investments,
    chosen for maximum diversification at a target return level. This portfolio will be optimal for
    investors with different risk tolerances. Asset allocation adjusts for risk tolerances. Some people
    tend to equate the idea of efficient markets with the CAPM. We have to be careful with this
    linkage however. If the CAPM assumptions and results are completely valid then the markets
    would have to be, de facto, informationally efficient. However if the CAPM is false this only
    says that our model of expected returns is wrong and it technically says nothing about
    information efficiency.

    4. Multifactor Models and the CAPM


    PPT 7-18 through PPT 7-20
    The aforementioned limitations of the CAPM theory eventually led to the development of
    multifactor models and the arbitrage pricing theory. These models either downplay or eliminate
    the central role of the market portfolio, which is unobservable anyway. The Fama-French (FF)
    three factor model has become a standard in equity analysis. The FF model was developed
    because the researchers found that stocks of smaller firms, and of firms with a high book-to-
    market ratio, had higher stock returns than predicted by single factor models. The FF model is
    based on empirical regularities that are apparently longstanding in the data. Nevertheless it is a
    model without a sound theoretical underpinning. This raises questions about whether the priced
    factors will remain significant in the future.

    5. Arbitrage Pricing Theory


    Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
    of McGraw-Hill Education.
    Solution Manual for Essentials of Investments 11th by Bodie

    Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

    PPT 7-21 through PPT 7-26


    After laying the conceptual groundwork and defining terms, the concept of arbitrage pricing for
    well- diversified portfolios is presented in the PPT. Arbitrage opportunities exist if an investor
    can construct a zero investment portfolio with a sure profit. If such opportunities exist, an
    investor can take large positions to secure riskless profits. In efficient markets, if profitable
    arbitrage opportunities exist, traders will take positions to secure the riskless profit and we
    should expect such opportunities to disappear quite quickly. The PPT also covers some of the
    most significant difference between the APT and the CAPM and some practical difficulties in
    using the APT.

    Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
    of McGraw-Hill Education.

    Visit TestBankBell.com to get complete for all chapters

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