INTEREST RATES AND RISK PREMIUMS by mustarhymes

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									                                CAPITAL ASSET PRICING MODEL (CAPM)

   Systematic versus unsystematic risk:
        Systematic risk—market (economic) risk that cannot be reduced through diversification.
        Unsystematic risk—risk unique to the firm/industry that can be reduced (theoretically to
         zero) through diversification
   Equilibrium model:
                            E (ri )  rf  RPi
                                       rf  RPM β i
                                       rf  [E(rM )  rf ]β i
                                                     Cov(ri , rM ) 
                                rf  [E(rM )  rf ]               
                                                        σ2
                                                          M         
   Security Market Line (SML)—a graphical depiction of the CAPM

                           E(r)

                                                                  Security Market Line (SML)

                                                                           E(rM )  rf
                 E(rM)                                           Slope                 E(rM )  rf
                                                                            1.0  0


                      rf


                                                                  


   Computing —beta is computed using the market model, which when graphed is termed the
    characteristic line:

                      ri,t = i + irM,t + i,t

    i represents the beta for a stock, i; it is a measure of the volatility of the stock's returns relative
    to the volatility of the market's return.
   CAPM shortcomings:
         assumptions
         testing the CAPM
   Practicality of the CAPM
   Portfolio beta:      P = w11 + w22 + … + wNN
                                                                              Stock Return
                                                                                 (GM)
                                                                                 30%


                                                                                 20%


                                                                                 10%


                                                                                  0%
                                                                                                                                 Market Return
                                -20%           -15%         -10%        -5%            0%         5%         10%           15%    (S&P 500)

                                                                                -10%
                                                                                             = intercept = 0,2%

                                                                                -20%
                                                        = slope = 1.20
                                                                                -30%


SUMMARY OUTPUT


        Regression Statistics
Multiple R              0.561453366
R Square                0.315229882
Adjusted R Square       0.303423501
Standard Error          0.097661962
Observations                       60


ANOVA
                            df                  SS                 MS            F          Significance F
Regression                             1      0.254660427     0.254660427     26.69995769      3.05702E-06
Residual                           58         0.553195811     0.009537859
Total                              59         0.807856238


                       Coefficients        Standard Error      t Stat          P-value       Lower 95%       Upper 95%      Lower 95.0%       Upper 95.0%
Intercept              -0.002148682           0.012610387    -0.170389864     0.865296529     -0.027391095    0.02309373    -0.027391095        0.02309373
X Variable 1             1.20181219           0.232584794     5.167200179     3.05702E-06       0.73624349   1.667380891         0.73624349    1.667380891

								
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