Investment and Portfolio Management: Professor Robert Kosowski

Investment and Portfolio
Management
Lecture 1: Portfolio Choice and CAPM
Review
Professor Robert Kosowski
© Imperial College Business School

My Brief Bio
• Head of the Department of Finance and Professor, Imperial College Business

School, Imperial College London.
• Prior to joining Imperial College London, Assistant Professor of Finance at
INSEAD where he taught in the MBA, Executive Education and PhD programs.
• Previously: Head of Quantitative Research (Part-time) Unigestion. Advisor to
private and public organizations (Specialist Advisor (UK House of Lords, 2009-
2010), Expert Technical Consultant (IMF, 2008, 2016)). Worked for Goldman
Sachs in London, the Boston Consulting Group in Germany and Deutsche
Bank in New York City. Consultant for IMF, SWFs and other financial services
firms.
• Research interests include asset pricing and financial econometrics with a
focus on the performance of hedge funds, business cycles, analyst
recommendations and derivatives trading. Awarded European Finance
Association 2007 and several INQUIRE UK Best Paper Awards
• Research published in top peer-reviewed finance journals such as The Journal
of Finance, Review of Financial Studies and The Journal of Financial
Economics and has been featured in publications such as The Financial Times
and The Wall Street Journal.
• BA and MA in Economics from Trinity College, Cambridge University, and a
MSc in Economics and PhD from the London School of Economics.
Imperial College Business School Imperial means Intelligent Business 2

Investment and Portfolio Management (IPM) Course
Overview
Expected
Asset Predictability
Return Models
Allocation in Returns
2. Multi-factor Models/
1. Portfolio Choice and 4. Term Structure
APT/CCAPM
CAPM Review of Interest Rates
3. Market Efficiency &
8. Options and 5. Interest Rate Risk
Behavioural Finance
Performance
Evaluation 6. Foreign Exchange
7. Commodities
Imperial College Business School Note: Numbers indicate the lecture in IPM Imperial means Intelligent Business 3
Lecture Overview
Part A: Mean-Variance portfolio choice and single index model
1. Motivation, Course Introduction, Readings
2. Index Model
Part B: How to derive, apply and test the CAPM
3. CAPM
4. Examples of Use: Applying the CAPM to Corporate Finance and Portfolio Management
5. Testing the CAPM
Appendix:
A. Steepest Capital Market Line
B. New Evidence on CAPM Based on Announcement Days
C. Roll Critique, Ex-Post Mean-Variance Efficiency and SML

Learning Outcomes – Lecture 1
By the end of this week, you will be able to:
● Calculate the optimal portfolio for a diversified investor
● Calculate the beta, systematic and firm-specific for a security
● Calculate the beta and alpha of a fund
● Derive the Capital Asset Pricing Model (CAPM)
● Test the CAPM
● Apply the CAPM to discount cashflows and value a company
● Apply the CAPM to fund performance and risk attribution

Review of Important Concepts
• What is systematic risk

non d iv market o
• What is idiosyncratic risk? d iv firm specific
• What is the relationship between expected
return and risk
• How are total risk and systematic risk
measured? B
• What is the difference
– between expected and realized return?
– between ex post and ex ante return
– between the windscreen and the rear view
mirror
IN
• Is the CAPM about the cross-section or the
time-series of returns?

1. Motivating Example (1), CAPM Application:
America’s Hottest Investor*
Never mind the rocky market. After a string of supersmart
calls, mutual fund manager Ken Heebner is putting up the
best numbers of his sterling career.
Since May 1998, Focus has an average annualized return
of 24%, the best ten-year record of any U.S. mutual fund,
compared with only 4% for Standard & Poor's 500.
Focus, which has $7.4 billion in assets, is already up 15%
in 2008 (as of May 19), but it is 2007 that will be
remembered as Heebner's pièce de résistance.
Fueled by big bets on energy, fertilizer, and metals, Focus Source: America’s Hottest
Investor* , Fortune Magazine,
soared 80% last year, vs. 5% for the S&P 500. "I told Ken it May 27, 2008,
was like he was walking between the raindrops," says CGM http://money.cnn.com/2008/0
5/23/magazines/fortune/birge
president Bob Kemp, who oversees sales and marketing at r_americas_hottest_investor.f
the firm, of the year Heebner had in 2007. ortune/index.htm?postversion
=2008052706

Motivating Example (2): Did Heebner’s fund beat the
market on a risk adjusted basis?
Source: http://finance.yahoo.com/q?s=CGMFX

From Mean-Variance to the CML: 2 Risky Assets (Debt and Equity)
• As an illustration, see the Mean-Standard Deviation Animation that
we created in https://www.edx.org/course/finance-essentials-mba-success-imperialx-icbs002
• P has highest Sharpe Ratio
– SR=(Excess Return/ St. Dev)
• Below you can see BKM Table 7.1
i
MVP
u
appiness
go.pt gjfdu
Utiaty I
• What position would
j
an investor with
Risk Aversion A=4 take in portfolio p?
• Assume that portfolio P consists of
40% debt and 60% equity. Appendix
A shows how to calculate these
percentages.
What position would an investor with Risk Aversion A=4 take in
portfolio p? Ecrcra y EGP TG g Erf YEAH It of
var win ya 244242 5of
Cup U 9 Ift E A y op
FOG E rp rt EXAy op
E ( rp ) − rf
O
0.11 − 0.05
y= = = 74.39%
A p2 4  0.142 2
ywD = 0.4  0.7439 = 29.76%

ywE = 0.6  0.7439 = 44.63%
ECD I J
of
skewness t

Why do we need a factor model?
• A variance covariance matrix is needed in one of the simplest examples
of a risk managed portfolio, the minimum variance portfolio (see graph)
• For this purpose we need to first calculate the sample covariance matrix
• But this becomes problematic when the number of assets (N) is of the
same order of magnitude or larger than the number of observations (T).
• Example:
• In typical applications, there can be over a thousand stocks to choose

from, but rarely more than ten years of monthly data (i.e. N = 1,000 and
T = 120).
• For background and references see
– https://systematicinvestor.wordpress.com/2012/02/26/portfolio-optimization-why-do-we-need-a-risk-model/

Single Factor Model
w's w
• Consider a single factor model that decomposes security return into
expected and unexpected component
ri = E (ri ) + ei , (
ei ~ N 0,  (ei )
2
)
• Consider a common (macro) factor
ri = E (ri ) + m + ei , where  i2 =  m2 +  2 (ei )
• Incorporate exposures to this macro factor

It
Mitt
ri = E (ri ) +  i m + ei
to
 i2 =  i2 m2 +  2 (ei )
Cov ri , rj = Cov  i m + ei ,  j m + e j ) =  i  j m2
( ) (

2. Single-index approach
• Pros/Cons of Single-factor approach
– Purely statistical and simple, but what is the factor?
• Single-index model
– Assume factor is equity market or S&P500
– Use regression (in excess return format) to estimate single index model
(e.g. for Amazon) which we call the Security Characteristic Line (SCL)
008

Index Model and Diversification
• Portfolio’s variance:
I EE Ece 52
 =   +
2
P
2
P
2
M
2
( eP )
of
f
• Variance of the equally weighted
portfolio of firm-specific
components:
2
II
1 2 n
1 2
 ( eP ) =     ( ei ) =  ( e )
2
i =1  n  n
• When n gets large,

E e
becomes negligible
 2 (eP )

Estimating Beta: SCL of Amazon
E EEE O
5 𝑅2
o
2 2
𝛽𝐴𝑀𝑍𝑁 𝜎𝑀𝑎𝑟𝑘𝑒𝑡
= 2 2
𝛽𝐴𝑀𝑍𝑁 𝜎𝑀𝑎𝑟𝑘𝑒𝑡 + 𝜎 2 (𝑒𝐴𝑀𝑍𝑁 )
= 0.2863
EA Ftp MRP
p Source: BKM (12th ed), Chapter 8, observations 2013- June 2018
Consider a DCF valuation exercise for AMZN (which does not pay dividends as of 8
Oct 2020). Using AMZN’s payout ratio of around 30% we can ask in thought
experiment what the value of AMZN should be given the following assumptions:
Payout ratio= Div/Net income=30%; Div(T+1)=30% x AMZN EPS(TTM)*(1+g)
RF (Bloomberg)=0.777% EPS(TTM 8 Oct 2020)=$26.04
MRP (my assumption)=5% Beta (BKM)=1.53
g=Growth rate of dividends (my assumption based on BBG EPS g of 14%)=8%
P =…. How does this compare to current price?
AMZN relative valuation from Bloomberg… for comparison
H
P I
EEEI.EE
Imperial College Business School
IEI.IE Imperial means Intelligent Business 16
Betas For Companies in Different Sectors (Jan 2020)
Industry Name
Number
of firms
leveredff
Beta D/E Ratio
Unlevered
beta 2015 2016 2017 2018 2019
Q
Utility (General) 16 0.28 66.95% 0.19 0.42 0.36 0.25 0.20 0.17
Power 52 0.58 72.51% 0.37 0.53 0.50 0.33 0.32 0.35
Retail (Grocery and Food)
Insurance (General)
13
19 o
0.59
0.74
96.66%
41.41%
0.34
0.57
0.75
0.80
0.77
0.82
0.46
0.71
0.44
0.63
0.28
0.67
Food Wholesalers 17 0.87 43.95% 0.65 1.26 0.61 0.93 1.41 1.23
Telecom. Equipment 91 0.89 17.22% 0.79 1.20 1.17 0.86 0.96 1.02
Restaurant/Dining 77 0.97 41.65% 0.74 0.74 0.64 0.61 0.70 0.65
Oil/Gas Distribution 24 1.02 89.69% 0.61 0.67 0.65 0.69 0.72 0.62
Investments & Asset Management 192 1.03 54.41% 0.73 0.73 0.81 0.68 0.87 0.87
Healthcare Products 242 1.04 13.25% 0.95 0.90 0.92 0.92 0.89 1.04
Telecom. Services 67 1.05 79.19% 0.66 0.69 0.57 0.68 0.72 0.74
Auto & Truck 13 1.10 164.93% 0.49 0.59 0.47 0.38 0.59 0.34
Retail (General) 18 1.14 32.10% 0.92 0.85 0.92 0.82 0.87 0.75
Aerospace/Defense 77 1.23 24.28% 1.04 1.06 1.20 0.94 0.99 1.09
Semiconductor 72 1.29 11.80% 1.18 1.17 1.32 1.11 1.16 1.26
TransportationE 18 1.31 54.23% 0.93 0.77 1.19 0.83 0.80 0.90
Air Transport 18 1.44 103.43% 0.81 0.61 0.85 0.76 0.67 0.63
Advertising 47 1.44 85.08% 0.88 0.83 0.74 0.91 0.78 0.87
Brokerage & Investment Banking 39 1.46 268.39% 0.48 0.41 0.46 0.42 0.54 0.46
Engineering/Construction 54 1.60 39.27% 1.23 1.19 1.07 1.01 1.13 0.81
Software (Internet) 30 1.67 20.41% 1.45 1.29 1.33 1.12 1.20 1.31
Shipbuilding & Marine 10 2.17 55.71% 1.53 0.94 0.84 0.85 1.01 0.78
See also http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/Betas.html

3. CAPM: Model of Expected Returns
• So far we assumed that the market index is used in the

single-index model
– Is there a model that tells us what to use as an index or
benchmark?
• CAPM
– It is the equilibrium model that underlies all modern financial
theory
– Derived using principles of diversification with simplified
assumptions
– Markowitz, Sharpe, Lintner and Mossin are researchers
credited with its development

Equilibrium – Capital Market Line (CML) and Security
Market Line (SML)
Mean - Std. Dev. Diagram (Assumptions) Mean - Beta Diagram (Predictio n)
Expected Return
Tangency (Market) Portfolio ' m'

Expected Return
Ie I
Tangency (Market) Portfolio
B
g
Security 1
Security 1
Security 2
Eam
Security 2
Security 3 Security 3
rf o rf GI
Std. Dev. Beta

of Return  =1
Capital market line
CAL O
Security market line
Important understanding check: Why can securities lie below CML, but cannot
below/above SML
CAPM Assumptions
1. Individual investors are price takers
2. Single-period investment horizon
3. Investments are limited to traded financial assets
4. No taxes and transaction costs
5. Information is costless and available to all investors
6. Investors are rational mean-variance optimizers
7. There are homogeneous expectations

CAPM Derivation: Using GE Example
• Covariance of GE return with the market portfolio:
it
 n
 n
Cov (rGE , rM ) = Cov rGE ,  wk rk  =  wk Cov (rGE , rk )
ape
 k =1  k =1 I
• Therefore, the reward-to-risk ratio for investments in GE would
be:
d
GE' s contribution to risk premium w E (r ) − r  E (r ) − r
GE GE f
É
GE f
= =
GE' s contribution to variance wGE Cov(rGE , rM ) Cov(rGE , rM )
f
Using GE Example Continued
• Reward-to-risk ratio for investment in market portfolio:
Market risk premium E (rM ) − rf
=
Market var iance  M2
• Reward-to-risk ratios of GE and the

09
market portfolio:
E (rGE ) − rf E (rM ) − rf
=
Cov (r GE , rM )  M2
• And the risk premium for GE:
Cov(r GE , rM )
E (rGE ) − rf =
 2
E (r ) − r  =  E (r ) − r 
M f GE M f
M

T.FI qq.IE
Imperial means Intelligent Business 22
The Index Model and Realized Returns
• To move from expected to realized returns—use the index

model in excess return form and regression:
Ri ,t =  i + i RM ,t + ei ,t
BERM E Rin
E eat
Ri term to
• The index model beta coefficient turns out to be the same
beta as that of the CAPM expected return-beta
relationship
RE BRI
• Why do investors care about systematic and not
idiosyncratic risk?
• What should be R-squared of this regression?

Applying the CAPM in practice
• Estimating the CAPM and Beta
• Tests of the CAPM

– Why test it ?
• New Evidence Based on Announcement Days

Bloomberg - Beta estimation Pads Braw 3 I t
Ss RN
realized
P
Bloomberg commands:
∙ AMZN Equity <GO> (type “AMZN” – press F8 – press Enter) Example of using
∙ BETA <GO> (type “beta” – press Enter) adjusted beta in long-
short portfolio in practice
(see also AJO case)

Example of exam style question
O
The correlation between the ABC corporation and the S&P 500
O
Index is 0.65. The standard deviation of the market is 18% and that
of ABC is 27%. The implied beta of ABC is closest to:
a. 1.06
b. 0.93
p.jo Ft
c. 1.20
coucaBc.m
d. 0.98
e. 1.23
Saban gfff.my fOMOABC
Baran STEEL JI
0.975
How the CAPM can be used to measure investment
performance – Alpha and Beta
• If a stock is perceived to be a good buy, or
TERI BIM
underpriced, it will provide an expected return in
i
excess of the fair return stipulated by the SML
(Security Market Line)
• The difference between the fair and the actually L

expected rate of return of the stock is called the stock’s
alpha
• For example, if the market return is expected to be

14%, a stock has a beta of 1.2, and the T-bill rate is
6%, the SML would predict an expected return on the
wow
stock of 6% + 1.2 (14-6)=15.6%.
• If one believed the stock would provide an expected i

return of 17%, the implied alpha would be 1.4% T
4. CAPM Application to Motivating
Example: CGM Focus
O O O
RI BIM
I
EFI
Source: downloaded on 7 October 2020 from http://finance.yahoo.com/q/rk?s=CGMFX

Exam style question
You are a portfolio analyst and in charge of evaluating portfolio A,
which consists entirely of UK common stocks. The table below shows
data on that portfolio and on a diversified portfolio of UK stocks (the
FTSE100), which you could think of as “the market”.
Average Standard Beta

Annual Rate Deviation of
of Return Return
Portfolio A 9 21 r 0.4 v
FTSE100 7
UK risk-free 2
Ou 11
N/A
u 1.00
N/A
rate
Which of the following is correct

a) The FTSE 100 is cheap
EE
t.IE
b) Portfolio A's Sharpe ratio is close to 0.50
c) Portfolio A's Sharpe ratio is close to 0.33
d) Portfolio A's return adjusted Sharpe ratio is negative
e) Portfolio A's Sharpe ratio is inconsistent with its beta
5. CAPM Tests: What the CAPM Predicts And How to Test It
Essence of CAPM: expected return on any asset is a positive

linear function of its beta and that beta is the only measure
of risk needed to explain the cross-section of expected
returns.
How to test it:

The basic idea of the approach is the use of a time series
(first pass) regression to estimate betas and the use of a
cross–sectional (second pass) regression to test the
hypothesis derived from the CAPM.

CAPM Test Methodology: Two-Pass Regression
• Step 1 (First-Pass Regression):

For each of the N securities included in the sample, we
first run the following regression over time to estimate beta:
O
𝑅𝑖𝑡 = 𝑟𝑖𝑡 − 𝑟𝑓𝑡 = α𝑖 + β𝑖 𝑅𝑚𝑡 + 𝑒𝑖𝑡 (1)
• Step 2 (Second-Pass Regression)

We run the following cross-section regression over the
sample period over the N securities:
1PMEff
𝑅ሜ 𝑖 = 𝑟𝑖 − 𝑟𝑓 = 𝛾0 + 𝛾1 β𝑖 for i=1,...,N(say 100 stocks) (2)
𝑅ሜ 𝑖 = 𝑟𝑖 − 𝑟𝑓 = 𝛾0 + 𝛾1 β𝑖 + 𝛾2 𝜎 2 𝑒𝑖 (2 extended)
Us
W
Hypothesis idiosyni Risk
Do 0 82 0
D E CR m
RFArithmetic historical time series
Imperial means Intelligent Business 31
average
Test Result: SML slope is “too flat” and intercept is “too
high”.
 0 = 0.127(0.006)  1 = 0.042(0.006)
0
 2 = 0.310(0.026) rM − rf = 0.165
Source: original Lintner (1965) coefficient estimates (standard errors), see BKM Ch.13.1

Lecture Summary
1. Motivation
2. Index Model
3. CAPM
4. Examples of Use: Applying the CAPM to Corporate
Finance and Portfolio Management
5. Testing the CAPM
Appendix:
New Evidence on CAPM Based on Announcement
Days

Appendix A: What is the portfolio with the Steepest Capital
Market Line?
E (rp ) − rf
Max SR wi
p =
p
wD =
E ( RD )  E2 − E ( RE ) Cov ( RD , RE )
E ( RD )  E2 + E ( RE )  D2 −  E ( RD ) + E ( RE )  Cov ( RD , RE )
=
(8 − 5) 400 − (13 − 5) 72 = 0.4
( )
8 − 5 400 + ( 13 − 5 ) 144 − ( 8 − 5 + 13 − 5 ) 72
E ( rp ) = (.4  8 ) + ( 0.6 13) = 11%
11 − 5
SRP =
14.2
Portfolio holds 40%

in bonds!
Appendix B: Recent resurrection for the CAPM (1): CAPM and
Announcement Days Return %
CAPM
Estimate
• Earlier tests over last 40 years: Market beta does not d SML
help explain the cross-section of stock returns
• Savor and Wilson (2013):

– Beta/returns (cross-section) and volatility/returns (time-series) Beta
relations look very differently depending on type of trading day

– Market beta is positively related to returns on announcement days
Certain important information is released in the form of prescheduled
announcements; If asset prices respond to this news, the risk of holding affected
assets will be higher around announcements
For individual stocks; Beta-sorted portfolios; Industry portfolios
Even for other assets (bonds, currencies, etc.)
– Beta is after all an important measure of systematic risk
What are scheduled macroeconomic news announcements?
• Employment: Jan 1964 – Dec 2011 (573 observations)
• CPI: Jan 1964 – Jan 1971 (85 observations)
• PPI: Feb 1971 – Dec 2011 (491 observations)
• PPI comes out before CPI every month
• FOMC interest rate decisions: Jan 1978 – Dec 2011 (294 observations)
• Unscheduled announcements are excluded

Appendix B: Recent resurrection for the CAPM (2)
Savor and Wilson (2013) Figure 1: Average Excess Returns for 10
Beta-Sorted Portfolios
18.0
16.0
14.0
A
v
.
12.0
E
x
c
10.0 o RP = 10.3 (t-stat = 13.7)
e
s Adj. R2 = 95.9%
s
8.0 Ann. Day
R Non Ann. Day
e
t
u 6.0
r
n
4.0 RP = -1.5 (t-stat = -3.7)
(
b
p Adj. R2 = 63.1%
s
2.0
)
0.0
0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8
-2.0
CAPM Beta
Source: Savor, Pavel G. and Wilson, Mungo Ivor, Asset Pricing: A Tale of Two Days (August 2013). AFA 2013
San Diego Meetings Paper. Available at SSRN: http://ssrn.com/abstract=2024422

Appendix B: Recent resurrection for the CAPM (3)
Table 1: Daily Excess Returns for 10 Beta-sorted Portfolios
Panel A: Fama-MacBeth regressions
Value-weighted Equal-weighted
Intercept Beta Av. R2 Intercept Beta Av. R2
A-Day 0.00013 0.00092 0.514 0.00089 0.00094 0.574
[0.90] [2.81] [8.59] [2.96]
N-Day 0.00020 -0.00010 0.492 0.00069 -0.00031 0.564

[3.64] [-0.89] [16.60] [-2.80]
A-Day - -0.00007 0.00103 0.00020 0.00126

N-day [-0.44] [2.89] [1.99] [3.57]
Panel B: Pooled regression
Value-weighted Equal-weighted
Ann. * Ann. *
2
Intercept Beta Ann. Beta R Intercept Beta Ann. Beta R2
0.00024 -0.00015 0.00016 0.00084 0.001 0.00079 -0.00039 0.00061 0.00119 0.001
[3.26] [-1.18] [0.81] [2.74] [10.55] [-2.85] [3.01] [3.62]
Source: Savor, Pavel G. and Wilson, Mungo Ivor, Asset Pricing: A Tale of Two Days (August 2013). AFA 2013
San Diego Meetings Paper. Available at SSRN: http://ssrn.com/abstract=2024422
Appendix C: Roll Critique, Ex-Post Mean-Variance Efficiency
and SML
The next slides

illustrate that if
we find an ex-
post mean-
variance efficient
portfolio, its
constituent
securities will lie
on the SML ! You
will be asked to
do the
calculations
yourself as part
of an APS

Example of the SML II

Example of the SML III

Example of the SML IV – The Graph
What is the difference between this and the Capital Marke Line (CML)?
Imperial College Business School Imperial means Intelligent Business 41 41

Example of the SML V - Differences between the CML and SML
The differences are:

– Every security will lie on the SML
– No security (other than the Mkt and the risk-free asset) will lie on the
CML.
– The SML can be thought of as showing the systematic risk only
– The asset locations in the CML plot show the total risk (systematic
and unsystematic)

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Investment and Portfolio

Professor Robert Kosowski

© Imperial College Business School

• Head of the Department of Finance and Professor, Imperial College Business

Imperial College Business School Imperial means Intelligent Business 2

1. Motivation, Course Introduction, Readings

Part B: How to derive, apply and test the CAPM

5. Testing the CAPM

A. Steepest Capital Market Line

B. New Evidence on CAPM Based on Announcement Days

C. Roll Critique, Ex-Post Mean-Variance Efficiency and SML

Imperial College Business School Imperial means Intelligent Business 4

By the end of this week, you will be able to:

● Calculate the optimal portfolio for a diversified investor

● Calculate the beta, systematic and firm-specific for a security

● Calculate the beta and alpha of a fund

● Derive the Capital Asset Pricing Model (CAPM)

● Test the CAPM

● Apply the CAPM to discount cashflows and value a company

● Apply the CAPM to fund performance and risk attribution

Imperial College Business School Imperial means Intelligent Business 5

• What is systematic risk

Imperial College Business School Imperial means Intelligent Business 6

Imperial College Business School Imperial means Intelligent Business 7

Imperial College Business School Imperial means Intelligent Business 8

ywD = 0.4  0.7439 = 29.76%

Imperial College Business School Imperial means Intelligent Business 10

• In typical applications, there can be over a thousand stocks to choose

Imperial College Business School Imperial means Intelligent Business 11

ri = E (ri ) + m + ei , where  i2 =  m2 +  2 (ei )

• Incorporate exposures to this macro factor

Imperial College Business School Imperial means Intelligent Business 12

Imperial College Business School Imperial means Intelligent Business 13

• When n gets large,

Imperial College Business School Imperial means Intelligent Business 14

See also http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/Betas.html

Imperial College Business School Imperial means Intelligent Business 17

• So far we assumed that the market index is used in the

Imperial College Business School Imperial means Intelligent Business 18

Tangency (Market) Portfolio ' m'

Std. Dev. Beta

1. Individual investors are price takers

2. Single-period investment horizon

3. Investments are limited to traded financial assets

4. No taxes and transaction costs

5. Information is costless and available to all investors

6. Investors are rational mean-variance optimizers

7. There are homogeneous expectations

Imperial College Business School Imperial means Intelligent Business 20

• Covariance of GE return with the market portfolio:

• Reward-to-risk ratios of GE and the

• And the risk premium for GE:

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• To move from expected to realized returns—use the index

Imperial College Business School Imperial means Intelligent Business 23

• Estimating the CAPM and Beta

• Tests of the CAPM

• New Evidence Based on Announcement Days

Imperial College Business School Imperial means Intelligent Business 24

Imperial College Business School Imperial means Intelligent Business 25

• The difference between the fair and the actually L

• For example, if the market return is expected to be