5. CAPM Flashcards
What does CAPM stand for?
Capital Asset Pricing Model.
What is the risk-free rate in the CAPM formula?
It represents the return on a risk-free investment, typically government securities.
What does the market portfolio in CAPM include?
The market portfolio includes all risky assets weighted by their market value.
What is the Security Market Line (SML)?
A graphical representation of the expected return-beta relationship in CAPM.
What is systematic risk in CAPM?
Systematic risk refers to market-wide risks that cannot be diversified away.
Explain the significance of the market risk premium in CAPM.
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.
How does the CAPM formula relate to an individual security’s expected return?
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.
What is the role of beta (β) in CAPM?
Beta measures a security’s sensitivity to market movements and determines its contribution to portfolio risk.
How is the Security Market Line (SML) used in investment decisions?
The SML helps investors assess whether a security is overvalued or undervalued based on its expected return and beta.
Why is diversifiable risk not compensated in CAPM?
Diversifiable risk can be eliminated through portfolio diversification, so it does not affect expected returns.
Analyze the relationship between the Capital Market Line (CML) and the Security Market Line (SML).
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.
Explain why the CAPM equilibrium condition ensures consistent reward-to-risk ratios across all securities.
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.
How does liquidity risk factor into CAPM extensions?
CAPM extensions incorporate liquidity risk by adding a liquidity beta term, which accounts for additional expected returns required to compensate for less liquid assets.
Compare the assumptions of CAPM with those of the single-index model.
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.
Evaluate the impact of systematic versus diversifiable risk on a portfolio’s expected return according to CAPM.
CAPM states that only systematic risk impacts expected returns, as diversifiable risk is eliminated in a well-diversified portfolio and does not require compensation.
Differentiate between the Capital Allocation Line (CAL) and the Capital Market Line (CML) in terms of portfolio optimization.
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.
Examine how the expected return-beta relationship in CAPM guides investment strategies.
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.
Assess the practical challenges in testing the CAPM model in real-world markets.
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.
Compare the roles of systematic risk and liquidity risk in shaping asset returns within CAPM extensions.
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.
Evaluate how CAPM influences the determination of the cost of capital for a firm.
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.
What is the formula for the proportion allocated to the risky portfolio in CAPM?
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.
How is the market risk premium calculated?
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.
What is the role of the covariance term in the CAPM formula?
The covariance term measures how much an individual security’s returns move in relation to the market, determining its systematic risk contribution.
How is the expected return for an individual stock calculated using CAPM?
E(ri) = rf + βi * (E(rM) - rf), where βi represents the stock’s beta.
What does the reward-to-risk ratio for a stock indicate?
It indicates the expected return per unit of systematic risk, calculated as E(R1) / Cov(RM, R1).
How is the beta (β) of a stock determined in CAPM?
Beta is calculated as β = Cov(RM, Ri) / σ²M, showing the sensitivity of a stock’s returns to market returns.
Why does CAPM use a risk-free rate in its calculations?
The risk-free rate serves as a baseline for returns, representing the return on an investment with no risk of default.
What is the significance of the Security Market Line (SML) equation?
The SML equation, E(ri) = rf + βi * (E(rM) - rf), illustrates the linear relationship between beta and expected return, guiding fair valuation of assets.
How does CAPM define the equilibrium condition in the market?
The equilibrium condition is E(R1) / Cov(RM, R1) = E(RM) / σ²M, ensuring all securities are priced to offer consistent reward-to-risk ratios.
What is the purpose of including liquidity risk in CAPM extensions?
Including liquidity risk accounts for the additional return investors require to compensate for assets that are harder to trade quickly without significant price impacts.
What assumptions about investor behavior does CAPM rely on?
CAPM assumes that investors are rational, risk-averse, and have homogeneous expectations about asset returns.
How does the concept of a market portfolio support CAPM?
The market portfolio represents a fully diversified portfolio of all risky assets, used as the benchmark for systematic risk and returns.
What distinguishes systematic risk from diversifiable risk in CAPM?
Systematic risk arises from market-wide factors and affects all assets, while diversifiable risk is asset-specific and can be eliminated through diversification.
How does the Capital Market Line (CML) illustrate efficient portfolios?
The CML shows the risk-return tradeoff for portfolios combining the risk-free asset and the market portfolio, with the highest Sharpe ratio.
Why is the beta coefficient important in evaluating a security?
Beta indicates the sensitivity of a security’s returns to market returns, helping investors assess its contribution to portfolio risk and expected return.
