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Two vital functions of the CAPM
 Provides a benchmark rate of return
 Help us determine the expected return on assets that have not yet been traded

6 assumptions of the CAPM
 There are many investors, each with small wealth compared to the total
 All investors plan for one identical investing period
 Investments are limited to a universe of publicly traded financial assets (stocks, bonds, riskfree)
 Investors pay no taxes on return and no transaction costs
 All investors are rational meanvariance optimizers
 All investors analyze securities in the same way and share the same economic view (homogeneous expectations)

Mutual fund theorem
Under the CAPM assumptions, the passive strategy of investing in a market index portfolio is efficient

Expected returnbeta relationship
 E(r_{i}) = r_{f} + β_{i}[E(r_{M})  r_{f}]
 Graphically this equation represents the SML

CAPM vs Capital Budgeting
When a firms enters a new project, the CAPM can provide the required rate of return that the projects needs to yield, based on its beta, to be acceptable to its investors. This yield is also called IRR or hurdle rate.

CAPM vs Index Model
 Both model yield to the same equation
 The only difference is that CAPM predicts expected return while the Index Model uses actual market index results
 β_{i} = Cov(R_{i}, R_{M}) / σ_{M}^{2}
 Market Model: r_{i}  E(r_{i}) = β_{i}[r_{M}  E(r_{M})] + e_{i}^{ }

Practicability of the CAPM
 If all α = 0, there would be no inventive to engage in security analysis
 A security is mispriced <=> α_{i} ≠ 0, where α_{i} can only be revealed by superior security analysis

The ZeroBeta Model
 Any PF that is a combination of two frontier PF is itself on the efficient frontier
 E(r_{i}) can be expressed as an exact linear function of E(r_{P}) and E(r_{Q}), where P and Q are two efficientfrontier portfolio
 Every portfolio on the efficient frontier (except global minvar) has a zerobeta portfolio on the bottom inefficient half of the frontier with which it is uncorrelated

Labor Income and Nontraded Assets
 A CAPM important departure from realism is that it ignores asset classes that are not traded:
 Human capital
 Privately held businesses

4 Extensions of CAPM
 Zeroβ: assumes unrestricted borrowing & lending is not possible → investors select a combination of mkt PF and a zeroβ PF, where E(z) > r_{f}
 Laborincome & nontraded assets: includes those factors
 Lifetime consumption and Intertemporal CAPM: may be more realistic to consider lifetime consumption plan where r_{f}, E(r_{M}), and σ_{M} change
 Consumptionbased CAPM: E(R_{i}) = β_{iC}RP_{C} where P_{C} is a consumptiontracking portfolio (disadv: consumption growth figures are published infrequently)

Liquidity
 Ease and speed with which an asset can be sold at a fair market value. It reflects (a) the cost of engaging a transaction, (b) the impact that your own selling has on the price, and (c) the immediacy or speed at which the transaction can occur.
 Less liquid assets tend to generate substantially higher returns
 Liquidity is an important characteristic that affects stocks' value

3 issues when testing CAPM
 Uses mkt PF which can't be reproduced
 Stated in E(r), but we only observe actual return
 Since uses E(r), we can't test linear relationship

3 add'l liquidity β that can be added to CAPM
 Sensitivity of security's illiquidity to mkt illiquidity
 Sensitivity of stock's return to mkt illiquidity
 Sensitivity of security's illiquidity to mkt return

