3.4 Capital Asset Pricing Model Flashcards
What does portfolio theory indicate?
- Diversify to eliminate non-systematic risk
- Hold only the risk-free asset and tangent portfolio
What do investors like? Why do investors like common stock portfolios?
- High expected return
- Low standard deviation
Common stock portfolios that offer this are known as efficient portfolios, hence they are liked.
What is two fund separation?
If the investor can lend or borrow at the risk-free rate, one efficient portfolio is better than all the others (the tangential portfolio).
What would a risk-averse and a risk-tolerant investor do?
Risk-averse: put part of her money in this efficient portfolio and part in the risk-free asset.
Risk-tolerant: put all their money in this portfolio or they might borrow and put in even more.
Two fund separation and tangency portfolio graphically
Suppose there are a total of i = 1, …, n risky assets. How do we find the market portfolio? (3)
Define market capitalisation
The total market value of the firm (as opposed to the book value).
Define market portfolio
The portfolio of all risky assets traded in the market.
What are the main assumptions?
- Investors agree on the distribution of asset returns (homogenous beliefs).
- Investors hold efficient frontier portfolios
- There is a risk-free asset
- Single period
- Demand of assets equal supply in equilibrium
What are the implications of CAPM? (3)
Every investor puts their money into two pots: risk-free asset and a single portfolio of risky assets (the tangent portfolio).
- All investors hold the risky assets in same proportions
- They hold the same risky portfolio, the tangent portfolio
- The tangent portfolio is the market portfolio
What are their asset holdings?
Market capitalisation of A, B, and C?
A = £750bn
B = £1500bn
C = £750bn
Total market capitalisation = 750 + 1500 + 750 = £3000bn
Why? In equilibrium, the total pound holding of each asst must equal its market value.
What is the market portfolio?
In the presence of a risk-free asset, what is a portfolio’s return?
What is the expected portfolio return? (equation)
What is the risk premium? (definition and equation)
What is risk (return volatility)?
The variance of portfolio returns is the sum of all values in the portfolio variance matrix.
Equation for the marginal contribution to portfolio variance
What is the marginal contribution of an asset to a portfolio?
Implication?
How can we get the CAPM equilibrium condition?
Suppose that CAPM holds. The expected market return is 14% and T-bill rate is 5%.
What should be the expected return on a stock with β = 0?
Same as the risk-free rate, 5%. BUT:
- The stock may have significant uncertainty in its return.
- This uncertainty is uncorrelated with the market return.
Suppose that CAPM holds. The expected market return is 14% and T-bill rate is 5%.
What should be the expected return on a stock with β = 1?
The same as the market return, 14%.
What should be the expected return on a portfolio made up of 50% T-bills and 50% market portfolio?
How can we decompose an asset’s return?
What does beta measure?
Implication for returns?
What does sigma measure?
What is the total variance of each return?
What does alpha measure?
What to do with an assets with a positive alpha?
- Check estimation error.
- Past value of ⍺ may not predict its future value.
- Positive ⍺ may be compensating for other risks.
What element are long run returns linked to?
Beta
Average risk premium and portfolio beta graph
Implications
How does CAPM determine the risk-return trade-off?
- Invest only in the risk-free asset and the market portfolio
- Beta measures systematic risk
- Required rate of return is proportional to beta
How is CAPM simple and sensible?
- It is built on modern portfolio theory
- It distinguishes systematic risk and non-systematic risk
- It provides a simple pricing model
How is CAPM controversial?
- It is difficult to test (to identify the market portfolio)
- Empirical evidence is mixed
- Alternative pricing models might do better
- Multiple factors
CAPM and capital structure
CAPM and cost of equity
CAPM and total cost of capital
Theta Industries’ operations exhibit a high amount of systematic risk as reflected by a beta of 2. Its investments are funded with one third of debt. The expected market return is 15% and safe investments yield 5%. Assume debt is risk-free.
Calculate Theta’s levered beta and equity cost of capital
Calculate its WACC
