The Issue
Richard de Neufville
CAPM
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Semantic Caution
Uses of the words risk and uncertainty
z
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CAPM
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Page 1
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CAPM
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Example
z
A Simple Game:
z
On Coin Toss
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CAPM
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Probability of Heads
Expected Value
= 50%
= $5
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CAPM
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Interpretation of Example
z
z
z
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CAPM
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Page 3
Bank
$10.00
$10.50
0.5
$12.00
Stock
$10.00
0.5
Engineering Systems Analysis for Design
Massachusetts Institute of Technology
$9.00
Richard de Neufville
CAPM
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Richard de Neufville
CAPM
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Non-satisfaction
For a given level of risk,
the preferred alternative
is one with the highest
expected return (A > C)
Risk Aversion
For a given level of
return, the preferred
alternative is one
with the lowest level
of risk (A > B)
Return
0
0
Risk
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CAPM
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CAPM
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z
z
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CAPM
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CAPM
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Risk free
U.S Treasuries
Fixed Income
Domestic Equity
International Equity
Real Estate
Venture Capital
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CAPM
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Greater Variability
=> Greater Expected Return
z
An upward trend
Expected Return
20
18
16
14
12
10
8
6
4
15
10
20
25
30
35
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CAPM
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CAPM
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Components of Uncertainty
z
z
z
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CAPM
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Diversification
z
Why is this?
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CAPM
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Role of Diversification
z
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CAPM
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CAPM
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p = (0.5)(0.5)(0.2)(0.2)(1)+ (0.5)(0.5)(0.2)(0.2)(1)+(2)(0.5)(0.5)(0.2)(0.2)ab
z
Portfolio
Standard
Deviation
20.0%
17.3%
14.1
0.0%
Portfolio
Expected
Return
20%
20%
20%
20%
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CAPM
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CAPM
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p = ijxixj i j ij =
z
portfolio variance
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CAPM
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CAPM
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z
z
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CAPM
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CAPM
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z
z
Return (%)
Risk-free
Frontier
Standard Deviation
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CAPM
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mix = xpp
Rp
Return (%)
Rf
Lend
Borrow
p
Standard Deviation
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CAPM
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Return (%)
CAPM
Line
Borrowing
Rp
Lending
Rf
p
Engineering Systems Analysis for Design
Massachusetts Institute of Technology
Standard Deviation
Richard de Neufville
CAPM
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z
z
Borrowing
Market Portfolio
Return (%)
Return (0%)
Borrowing
Market Portfolio
Rm
Rp
Lending
Rf
Rf
Standard Deviation
Bm
Beta
Richard de Neufville
CAPM
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Return (0%)
Rp = Rf + Bp*(Rm - Rf)
Rm is expected return of market portfolio
Rm - Rf is the market risk premium
Bp = beta of investment
to be evaluated
Rm
Borrowing
Market Portfolio
Lending
Rf
Bm
Engineering Systems Analysis for Design
Massachusetts Institute of Technology
Beta
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CAPM
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CAPM
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CAPM
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Difficulties in Practice
z
z
z
z
z
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CAPM
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Summary
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z
z
z
z
z
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CAPM
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