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CAPITAL ASSET PRICING MODEL (CAPM)

The capital asset pricing model (CAPM) operates under the assumption that investors are risk adverse. Investors who take on risk through the purchase of an investment must be compensated for that risk through a higher expected rate of return known as the risk premium. A security's risk is measured by its beta. Therefore, securities with higher betas must offer investors a higher expected return in order for the investor to be compensated for taking on the additional risk associated with that investment.

EFFICIENT MARKET THEORY

The efficient market theory believes that all of the available information is priced into the market at any given time and that it is impossible to beat the market by taking advantage of price or time inefficiencies. Proponents of the efficient market theory may follow the theory in the following ways:

Weak-form efficiency: States that the future price of a security cannot be predicted by studying the past price performance of the security. This form of the theory believes that technical analysis cannot produce excess returns.

Semi-strong form efficiency: States that the market price of a security adjusts too rapidly to newly available information to achieve an excess return by trading on that information.

Strong-form efficiency: States that the current price of a security reflects all information known and unknown to the public and that there is no opportunity to earn excess returns.

EXPECTED RETURN

Modern portfolio managers try to manage risk and evaluate investments by employing a variety of concepts under modern portfolio theory. Modern portfolio theory states that the expected rate of return for an investment is the sum of its weighted returns. An investment's weighted return is its possible return multiplied by the likelihood of that return being realized. The following table details the expected return for XYZ:

Expected Return

Weighted Return

Outperform

20%

25%

5%

Market perform

50%

5%

Underperform

5%

25%

1.25%

Expected return

11.25%

The following table details the expected return for ABC:

Expected Return

Probability of Expected Return

Weighted Return

Outperform

40%

10%

4%

Market perform

20%

70%

14%

Underperform

(33.75%)

20%

(6.75%)

Expected return

11.25%

Notice that the expected rate of return for both XYZ and ABC is 11.25 percent. However, an investment in XYZ contains less risk than an investment in ABC because the distribution of potential returns is not as wide as the distribution of potential returns for ABC. An investor who is considering investing in either XYZ or ABC would consider the 11.25 percent expected return offered by XYZ to be more attractive than the same expected return offered by ABC. The distribution of an investment's varying expected returns is measured by the investment's standard deviation. The wider the distribution of an investment's expected returns, the greater its standard deviation. Investments with higher standard deviations contain more risk than investments with lower standard deviations. As an investment's results are plotted over time, there is a 95 percent chance that its actual return will be within two standard deviations of its expected return and a 67 percent chance that it will be within one standard deviation of its expected return. Portfolio managers will use computer simulations to examine the possibilities of various portfolio strategies. The Monte Carlo simulation is one such simulation used by portfolio managers.

 
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