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Assumptions
Individual investors are price takers
Single-period investment horizon Investments are limited to traded financial assets No taxes, and transaction costs
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Assumptions (cont.)
Information is costless and available to all investors Homogeneous expectations
sM
E (ri ) rf i E (rM ) rf
M = Market portfolio rf = Risk free rate E(ri) - rf = Risk premium on security i E(rM) - rf = Market risk premium
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E (r
) rf 0.08
and
r f 0.03
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Application
You are in an economy where Rf=9%, E(Rm)=20%. Determine the equation of the SML line in this economy. A stock has a beta=1.5. Determine the required rate of return. Give your recommendation when you think its expected return will be 22%. Do the same analysis when beta=-0.5 and investor expect the return to be 7%
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Multifactor Models
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Arbitrage - arises if an investor can construct a zero beta investment portfolio with a return greater than the risk-free rate If two portfolios are mispriced, the investor could buy the low-priced portfolio and sell the high-priced portfolio In efficient markets, profitable arbitrage opportunities will quickly disappear
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E (rP ) r f P E (rM ) r f
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