Probability Dstributions of Risky Asset Returns

For the probability distribution of risky asset returns, we assume the following. Because the return is a random variable with a joint normal distribution, investors focus only on the average and variance of yields (Fama and French 2004). In other words, all portfolios created from a single asset or a combination of other portfolios must have a distribution that continues to be determined by their mean and variance. The portfolio returning to the multivariate of normal distribution also has the benefit of regular allocation.

CAPM attempts to pricing securities by examining the relationship between expected returns and risk. This model means that investors always combine two types of assets or securities, risk-free assets and risk assets in the form of market combinations of various assets. CAPM further assumes that investors desire to hold these risk assets based on the risks taken over by such assets. After all, since this risk can not be dispersed (market correlation is often called systemic risk), investors need to be compensated to take on this "indivisible" risk. Thinking it is intuitive. Let's see an example.

The discount rate is often referred to as the expected rate of return. This is to indicate the remuneration that it wishes to hold this dangerous asset for a long time. In order to lower the expected rate of return because the risk of assets seems to be low, it is necessary to lower the fee. Then you can purchase assets at a slightly higher price. For example, if you use a discount rate of 30% you get a reasonable market price of $ 0.54. If this confuses you, do not worry, it is a little counterintuitive and takes time to absorb

For the probability distribution of risky asset returns, we assume the following. Because the return is a random variable with a joint normal distribution, investors focus only on the average and variance of yields (Fama and French 2004). In other words, all portfolios created from a single asset or a combination of other portfolios must have a distribution that continues to be determined by their mean and variance. The portfolio returning to the multivariate of normal distribution also has the benefit of regular allocation.

Sharpe and Lintner assume that in their own CAPM model, the return on risky assets is not related to market rate of return. In their model, beta will be zero if the covariance of asset revenues offset the variance of other asset revenues. If borrowings and loans are risk free and asset returns are not related to market revenue, asset revenue is equal to risk free interest rate. In the Sharpe - Lintner model, the relationship between asset return and β is expressed by the following equation.