5. CAPM

Question 1

What does CAPM stand for?

Answer 1

Capital Asset Pricing Model.

Question 2

What is the risk-free rate in the CAPM formula?

Answer 2

It represents the return on a risk-free investment, typically government securities.

Question 3

What does the market portfolio in CAPM include?

Answer 3

The market portfolio includes all risky assets weighted by their market value.

Question 4

What is the Security Market Line (SML)?

Answer 4

A graphical representation of the expected return-beta relationship in CAPM.

Question 5

What is systematic risk in CAPM?

Answer 5

Systematic risk refers to market-wide risks that cannot be diversified away.

Question 6

Explain the significance of the market risk premium in CAPM.

Answer 6

The market risk premium represents the additional return expected from investing in the market portfolio instead of a risk-free asset, reflecting compensation for systematic risk.

Question 7

How does the CAPM formula relate to an individual security’s expected return?

Answer 7

The formula E(ri) = rf + βi * (E(rM) - rf) shows that a security’s expected return depends on the risk-free rate, its beta, and the market risk premium.

Question 8

What is the role of beta (β) in CAPM?

Answer 8

Beta measures a security’s sensitivity to market movements and determines its contribution to portfolio risk.

Question 9

How is the Security Market Line (SML) used in investment decisions?

Answer 9

The SML helps investors assess whether a security is overvalued or undervalued based on its expected return and beta.

Question 10

Why is diversifiable risk not compensated in CAPM?

Answer 10

Diversifiable risk can be eliminated through portfolio diversification, so it does not affect expected returns.

Question 11

Analyze the relationship between the Capital Market Line (CML) and the Security Market Line (SML).

Answer 11

The CML represents the risk-return tradeoff for efficient portfolios combining the risk-free asset and the market portfolio, while the SML shows the expected return for individual securities based on their beta and systematic risk.

Question 12

Explain why the CAPM equilibrium condition ensures consistent reward-to-risk ratios across all securities.

Answer 12

The CAPM equilibrium condition, E(R1)/Cov(RM, R1) = E(RM)/σ²M, ensures that every security’s expected return is proportional to its contribution to market risk, maintaining consistency in compensation for risk.

Question 13

How does liquidity risk factor into CAPM extensions?

Answer 13

CAPM extensions incorporate liquidity risk by adding a liquidity beta term, which accounts for additional expected returns required to compensate for less liquid assets.

Question 14

Compare the assumptions of CAPM with those of the single-index model.

Answer 14

CAPM assumes a fully diversified market portfolio, no taxes or transaction costs, and homogeneous expectations, while the single-index model focuses on the relationship between a security’s returns and the market index, without requiring all CAPM assumptions.

Question 15

Evaluate the impact of systematic versus diversifiable risk on a portfolio’s expected return according to CAPM.

Answer 15

CAPM states that only systematic risk impacts expected returns, as diversifiable risk is eliminated in a well-diversified portfolio and does not require compensation.

Question 16

Differentiate between the Capital Allocation Line (CAL) and the Capital Market Line (CML) in terms of portfolio optimization.

Answer 16

The CAL applies to any portfolio combination of a risk-free asset and a risky portfolio, while the CML specifically represents the efficient frontier when the risky portfolio is the market portfolio.

Question 17

Examine how the expected return-beta relationship in CAPM guides investment strategies.

Answer 17

The expected return-beta relationship helps investors select securities based on their risk (beta) relative to the market, enabling alignment with desired risk-return tradeoffs.

Question 18

Assess the practical challenges in testing the CAPM model in real-world markets.

Answer 18

Testing CAPM faces challenges like estimating the true market portfolio, the difficulty of measuring betas accurately, and accounting for factors like liquidity and market inefficiencies.

Question 19

Compare the roles of systematic risk and liquidity risk in shaping asset returns within CAPM extensions.

Answer 19

While systematic risk is inherent to market-wide movements and compensated by the market risk premium, liquidity risk is an additional factor that requires compensation for assets less easily traded.

Question 20

Evaluate how CAPM influences the determination of the cost of capital for a firm.

Answer 20

CAPM is used to estimate the cost of equity capital by relating a firm’s beta to the expected market return, helping firms assess project viability and shareholder value creation.

Question 21

What is the formula for the proportion allocated to the risky portfolio in CAPM?

Answer 21

y = (E(rM) - rf) / (A * σ²M), where y is the proportion, E(rM) is the expected market return, rf is the risk-free rate, A is the investor’s risk aversion, and σ²M is the market variance.

Question 22

How is the market risk premium calculated?

Answer 22

The market risk premium is given by E(rM) - rf, where E(rM) is the expected return of the market portfolio, and rf is the risk-free rate.

Question 23

What is the role of the covariance term in the CAPM formula?

Answer 23

The covariance term measures how much an individual security’s returns move in relation to the market, determining its systematic risk contribution.

Question 24

How is the expected return for an individual stock calculated using CAPM?

Answer 24

E(ri) = rf + βi * (E(rM) - rf), where βi represents the stock’s beta.

Question 25

What does the reward-to-risk ratio for a stock indicate?

Answer 25

It indicates the expected return per unit of systematic risk, calculated as E(R1) / Cov(RM, R1).

Question 26

How is the beta (β) of a stock determined in CAPM?

Answer 26

Beta is calculated as β = Cov(RM, Ri) / σ²M, showing the sensitivity of a stock’s returns to market returns.

Question 27

Why does CAPM use a risk-free rate in its calculations?

Answer 27

The risk-free rate serves as a baseline for returns, representing the return on an investment with no risk of default.

Question 28

What is the significance of the Security Market Line (SML) equation?

Answer 28

The SML equation, E(ri) = rf + βi * (E(rM) - rf), illustrates the linear relationship between beta and expected return, guiding fair valuation of assets.

Question 29

How does CAPM define the equilibrium condition in the market?

Answer 29

The equilibrium condition is E(R1) / Cov(RM, R1) = E(RM) / σ²M, ensuring all securities are priced to offer consistent reward-to-risk ratios.

Question 30

What is the purpose of including liquidity risk in CAPM extensions?

Answer 30

Including liquidity risk accounts for the additional return investors require to compensate for assets that are harder to trade quickly without significant price impacts.

Question 31

What assumptions about investor behavior does CAPM rely on?

Answer 31

CAPM assumes that investors are rational, risk-averse, and have homogeneous expectations about asset returns.

Question 32

How does the concept of a market portfolio support CAPM?

Answer 32

The market portfolio represents a fully diversified portfolio of all risky assets, used as the benchmark for systematic risk and returns.

Question 33

What distinguishes systematic risk from diversifiable risk in CAPM?

Answer 33

Systematic risk arises from market-wide factors and affects all assets, while diversifiable risk is asset-specific and can be eliminated through diversification.

Question 34

How does the Capital Market Line (CML) illustrate efficient portfolios?

Answer 34

The CML shows the risk-return tradeoff for portfolios combining the risk-free asset and the market portfolio, with the highest Sharpe ratio.

Question 35

Why is the beta coefficient important in evaluating a security?

Answer 35

Beta indicates the sensitivity of a security’s returns to market returns, helping investors assess its contribution to portfolio risk and expected return.