Lecture 7 CAPM and cost of capital.pdf

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1、Diversification,theCapitalAssetPricingModel,andtheCostofEquityCapitalBoSun1DIVERSIFICATIONREDUCESVOLATILITYINVESTORSCOMPENSATEDFORNON-DIVERSIFIABLERISKOFPORTFOLIORETURNVolatilityofportfolioreturnMarketvolatility05101520Numberofinaportfoliostocks2DiversificationWorks!3Effectofdiversification

2、•Firm-specificriskcanbereduced,ifnoteliminated,byincreasingthenumberofinvestmentsinyourportfolio(i.e.,bybeingdiversified).Market-wideriskcannot.Thiscanbejustifiedoneconomicgrounds.•Oneconomicgrounds,diversifyingandholdingalargerportfolioeliminatesfirm-specificriskfortworeasons-(a)Eachinve

3、stmentisamuchsmallerpercentageoftheportfolio,mutingtheeffect(positiveornegative)ontheoverallportfolio.(b)Firm-specificactionscanbeeitherpositiveornegative.Inalargeportfolio,itisargued,theseeffectswillaverageouttozero.(Foreveryfirm,wheresomethingbadhappens,therewillbesomeotherfirm,wheresomet

4、hinggoodhappens.)4MARKETPORTFOLIOIntheory:amarket-value-weightedportfolioofallexistingsecuritiesInpractice:S&P500•Assumingdiversificationcostsnothing(intermsoftransactionscosts),andthatallassetscanbetraded,thelimitofdiversificationistoholdaportfolioofeverysingleassetintheeconomy(inproportio

5、ntomarketvalue).Thisportfolioiscalledthemarketportfolio.•Individualinvestorswilladjustforrisk,byadjustingtheirallocationstothismarketportfolioandarisklessasset(suchasaT-Bill)PreferredrisklevelAllocationdecisionNorisk100%inT-BillsSomerisk50%inT-Bills;50%inMarketPortfolio;Alittlemorerisk25%in

6、T-Bills;75%inMarketPortfolioEvenmorerisk100%inMarketPortfolio•Everyinvestorholdssomecombinationoftheriskfreeassetandthemarketportfolio.5DiversificationandPortfolioRisk•Diversificationcansubstantiallyreducethevariabilityofreturnswithoutanequivalentreductioninexpectedreturns.•Thisreductioninr

7、iskarisesbecauseworsethanexpectedreturnsfromoneassetareoffsetbybetterthanexpectedreturnsfromanother.•However,thereisaminimumlevelofriskthatcannotbediversifiedaway,andthatisthesystematicportion.6PortfolioRiskandNumberofStocksInalargeportfoliothevariancete