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1 Capital Asset Pricing Model (CAPM) - Columbia University

Copyrightc 2005 by Karl Sigman1 Capital Asset Pricing Model (CAPM)We now assume an idealized framework for an open market place, where all the risky assetsrefer to (say) all the tradeable stocks available to all. In addition we have a risk-free Asset (forborrowing and/or lending in unlimited quantities) with interest raterf. We assume that allinformation is available to all such as covariances, variances, mean rates of return of stocksand so on. We also assume that everyone is a risk-averse rational investor who uses the samefinancial engineering mean-variance portfolio theory from Markowitz.

and hence has a portfolio that is a mixture of the risk-free asset and a unique efficient fund F (of risky assets). In other words, everyone sets up the same optimization problem, does the same calculation, gets the same answer and chooses a portfolio accordingly. This efficient fund used by all is called the market portfolio and is denoted by M.

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