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Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
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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
Information is
costless and available
to all investors
Investors are rational
mean-variance
optimizers
There are
homogeneous
expectations
INVESTMENTS | BODIE, KANE,
MARCUS
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GE Example
Covariance of GE return with the
market portfolio:
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GE Example
Reward-to-risk ratio for investment in
market portfolio:
Market risk premium E (rM ) rf
Market variance
M2
Cov rGE , rM
E rM rf
M2
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GE Example
The risk premium for GE:
COV rGE , rM
E rGE rf
E rM rf
2
M
Restating, we obtain:
E rGE rf GE E rM r f
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Expected Return-Beta
Relationship
P wk k
k
E (rM ) rf M E (rM ) rf
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Ri i i RM ei
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Liquidity Risk
In a financial crisis, liquidity can
unexpectedly dry up.
When liquidity in one stock decreases, it
tends to decrease in other stocks at the
same time.
Investors demand compensation for
liquidity risk
Liquidity betas
INVESTMENTS | BODIE, KANE,
MARCUS