1.3: Portfolio & CAPM Theory Flashcards
What does portfolio theory assume?
That investors only care about the overall mean and variance of their portfolios
- mean is good
- variance is bad
What is an efficient portfolio?
A portfolio that only contains systematic risk, and hence cannot be diversified further. No other portfolio offers a higher expected return with lower volatility
What is a natural candidate for an efficient portfolio?
The market portfolio; a portfolio of all stocks and securities traded in the capital market. Common practice is to use the S&P 500 as an approximation.
How can be measure the systematic risk of a security?
By calculating the sensitivity of the security’s return to the return of the market portfolio, which is the beta of the security
What is the beta of a security?
The expected percentage change in its return given a 1% change in the return of the market portfolio
What is the average of beta of a stock in the market?
About 1:
- cyclical industries have revenues that vary greatly over the business cycle and hence betas over 1
- non-cyclical firms tend to have betas less than 1
What is the market risk premium?
The difference between the market portfolio’s expected return and the risk-free interest rate. It reflects investors’ risk tolerance and determines the market price of risk in the economy. The reward investors expect to earn for holding a portfolio with a beta of 1 (the market portfolio)
What is the equation for estimating the cost of capital often referred to as?
The Capital Asset Pricing Model (CAPM).
What is an inefficient portfolio?
A portfolio where it is possible to find another portfolio that is better in terms of both expected return and volatility
What effect does correlation have on the expected return and volatility of a portfolio?
- No effect on expected return
- The lower the correlation, the lower the volatility we can obtain. The curve showing the portfolios will bend to the left to a greater degree.
What are the benefits of diversification when stocks are perfectly correlated?
No benefits.
What is a short sale/short position?
Investing a negative amount in a stock. You sell a stock today that you do not own, with the obligation to buy it back in the future (negative weight in portfolio)
When is short selling profitable?
When the stock’s price declines in the future
What is the efficient frontier?
The curve that connects the efficient portfolios
What is an alternative way to reduce risk, besides diversification?
Keeping some of our money in a safe, no-risk investment like treasury bills (but it will reduce expected return)
What can aggressive investors do if they want to be able to invest more in the stock market?
Borrow money
What is the volatility and covariance of a risk-free asset with a portfolio?
Both are zero, since the risk-free rate is fixed and does not move with the portfolio
What is a levered portfolio?
A portfolio that consists of a short position in the risk-free investment
What is the Sharpe ratio?
The slope of a line through a given portfolio P. It measures the ratio of reward-to-volatility provided by a portfolio.
What is the optimal portfolio to combine with a risk-free asset?
The one with the highest Sharpe ratio, where the line is tangent to the efficient frontier of risky investments. The portfolio that generates this tangent line is known as the tangent portfolio
Why should every investor invest in the tangent portfolio, independent of their taste for risk?
Once we include the risk-free investment, all efficient portfolios are combinations of the risk-free investment and the tangent portfolio. Preferences only determine how much to invest in the tangent portfolio versus the risk-free investment. They will earn the highest possible expected return for any level of volatility they are willing to bear
What is the required return?
The expected return that is necessary to compensate for the risk investment i will contribute to portfolio p
When should we keep adding more of a stock to the portfolio?
When its expected return exceeds the required return
When are our holdings optimal in a portfolio?
When required return of every security is equal to its expected return
What does the CAPM allow us to do?
Identify the efficient portfolio of risky assets without having any knowledge of the expected return of each security
What are the three assumptions for the CAPM?
- Investors can buy and sell all securities at competitive market prices (without incurring taxes or transaction costs) and can borrow and lend at the risk-free interest rate.
- All investors hold only efficient portfolios of traded securities.
- Investors have homogeneous expectations regarding the volatilities, correlations, and expected returns of securities.
Why must the tangent portfolio equal the market portfolio under the CAPM?
Demand must equal supply
What is the tangent line called when it goes through the market portfolio?
The Capital Market Line (CML)
What do we have on the axes when plotting the CML?
Expected return and volatility
Why is the right measure of risk the investment’s beta with the market portfolio, under CAPM?
Because investors can eliminate firm-specific risk by diversifying their portfolios
What is the Security Market Line (SML)?
It shows the expected return for each security as a function of its beta with the market (linear relationship). According to CAPM, all stocks and portfolios should lie on the SML
What do we have on the axes when plotting the SML?
Expected return and Beta
What is the beta of a portfolio?
The weighted average beta of the securities in the portfolio
What are the two major conclusions of the CAPM?
- The market portfolio is the efficient portfolio; the highest expected return for any given level of volatility is obtained by a portfolio on the capital market line, which combines the market portfolio with risk-free saving or borrowing.
- The risk premium for any investment is proportional to its beta with the market. Therefore, the relationship between risk and the required return is given by the security market line.
When can the market portfolio be inefficient?
Only if a significant number of investor either:
- Misinterpret information and believe they are earning a positive alpha when they are earning a negative alpha
- Care about aspects of their portfolios other than expected return and volatility (willing to hold inefficient portfolios)
What do we need to know to implement the CAPM?
- How to compute betas for each stock
- The risk-free rate
- The market risk premium
What is the cost of capital?
The best expected return available available in the market on investments with similar risk
What is the market capitalisation?
The total market value of a firm’s outstanding shares
What is a value-weighted portfolio?
Each security is held in proportion to its market capitalisation, for example the market portfolio. (also an equal-ownership portfolio and passive)
What is an equal-ownership portfolio?
we hold an equal fraction of the total number of shares outstanding of each security in the portfolio
Do we need to trade to maintain a value-weighted portfolio when market prices change?
No, unless the number of shares outstanding of some security changes
What are some common market indexes?
- S&P 500
- Wilshire 5000
- Dow Jones Industrial Average
How can you invest in market indexes?
- index funds that invest in the portfolios
- ETFs
What does the risk-free interest rate in CAPM correspond to?
The risk-free rate at which investors can both borrow and save. Generally determined by the risk-free saving rate using yields on treasury securities
What are possible explanations to why the market risk premium has declined over time?
- More investors participate in the stock market today, so risk can be shared more broadly.
- Financial innovations such as mutual funds and ETFs have greatly reduced costs of diversifying.
- Except for the 2008 financial crisis, the overall volatility of the market has declined over time.
What does alpha represent in linear regression of the best-fitting line?
A risk-adjusted performance measure for the historical returns. It is the difference between a stock’s expected return and required return according to SML.
- Positive = stock har performed better than predicted by CAPM
- Negative = stock’s historical return is below the SML
What is the alpha when the market portfolio is efficient?
- All stocks are on the SML
What is the formula for the Sharpe ratio?
Sharpe = Portfolio excess return / Portfolio volatility = (E(Rp) - rf) / SD(Rp)
What is the formula for the market value/capitalization?
MV = Number of shares outstanding * price per share