6. CAPM Flashcards
What is the equation used to measure Beta?
where:
oim = the covariance between the stocks return and the markets return
o2m = variance of the markets return
What is total risk equal to?
total risk = market risk + specific risk
What does it mean if Amazon stock has a Beta of 1.55?
If we assume this carries on, say the market increases by 1%, amazon will rise by 1.55%.
Similarly, if the market falls by 2%, Amazon’s stock price will fall by 3.1% (2 * 1.55)
What does it mean if a BETA is greater than 1?
BETA > 1 = Stocks that move more than one-for-one with the overall market. Most examples include luxury companies, eg. porsche. When the economy does well, consumers buy more goods.
What does it mean if a BETA is between 0 and 1?
0 < BETA < 1 = Stocks that still go up in the market bus less than one-for-one. Most examples include necessity companies. When the economy does well, they will only see slight increases, whereas as it falls, it will see only a smaller drop.
What does it mean if a BETA is smaller than 1?
0 > BETA = A negative beta is possible in theory. Such a stock does well when the economy does poorly. Hard to find concrete examples…
What is the “market portfolio”?
The true market portfolio contains all the world’s risky assets
-> so not limited to only US stocks.
Is it possible to find an accurate value of the “market portfolio”?
NO.
There is no index that measures the value of all risky assets.
Therefore, investors use a PROXY (an approximation) for the market portfolio.
-> Most often an investor will use a proxy in their home countries’ stocks, eg. in the USA many use the S&P composite index as their benchmark.
Why do betas determine portfolio risk?
“The beta of a portfolio is the weighted average of the betas of the individual stocks within that portfolio”
As beta measures undiverifiable risk to begin with, there is no diversification effect when adding a stock to a portfolio.
-> the beta of a portfolio is simply the weighted-average beta of the stocks in the portfolio
What does this curved line show?
The curved line illustrates how expected return and standard deviation change as you hold different combinations of both stocks…
-> In the example above, holding 60% Southwest and 40% Amazon results in an expected return of 13% with a standard deviation of 22%
What does the gain of diversification depend on?
The gain from diversification depends on how highly the stocks are correlated
If the correlation is 1, what would the impact of diversification be?
If the correlation is 1, there would be no gain from diversification
If the correlation is - 1, what would the impact of diversification be?
If the correlation is -1 (unrealistic), the combination of both stocks would have NO risk
What does portfolio A offer?
Efficient portfolio (as its on the curve)
Offers the lowest risk
What does portfolio C offer?
Efficient portfolio (on the curve)
Offers the highest returns, but also the highest risk
How can you exist outside the efficient frontier?
if you can lend or borrow at the risk-free rate of interest!
If you invest in portfolio S and lend and borrow at the risk free interest rate, rf, what can you achieve?
You can achieve any point along the straight line from rf through to S.
What is the Sharpe Ratio?
The ratio of the risk premium to the standard deviation is called the Sharpe Ratio
What is the equation of the “sharpe ratio”?
-> rf is risk free interest rate
Investors will track Sharpe ratios to measure the risk-adjusted performance of investment managers
What is the “Capital Asset Pricing Model”?
The capital asset pricing model (CAPM) states that the expected risk premium on each investment is proportional to its beta. This means that each investment should lie on the sloping security market line connecting Treasury bills and the market portfolio.
What is the blue line called?
Security Market Line
What is the equation of the CAPM ratio?
where:
r = expected return
rf = risk-free rate of interest
rm = expected return on market portfolio
Beta = sensitivity of a stocks return to the return on the market portfolio
The security market line is essentially the _____ equation plotted
The CAPM equation plotted
What are some key assumptions about CAPM?
- investing in US treasury bills is risk-free
- Investors can borrow money at the same rate of interest at which they can lend
-> usually borrowing rates are higher than lending rates - all assets are marketable
Would you buy stock A?
NO. Investors would never buy stock A.
Instead of buying stock A, investors would prefer to lend part of their money and put the balance in the market portfolio. And instead of buying stock B, they would prefer to borrow and invest in the market portfolio.
What is the difference between the capital market line and the security market line?
Capital market line:
- applies to efficient portfolios
- portfolios that bear specific risk lie below the line
- investor could still want to hold a stock below the market line as it is diversifiable
Security market line:
- applies to any stock or portfolio (can be inefficient)
- horizontal axis is Beta which is the market risk and undiversifiable
- the investor would be unwilling to hold stocks below the line
Are returns unrelated to all other characteristics?
Empirical evidence shows that other factors (than Beta) might drive different expected returns
What is a possible alternative to CAPM?
Arbitrage Pricing Theory
What does “Arbitrage Pricing Theory” assume?
Assumes that each stock’s return depends partly on pervasive macroeconomic influences of “factors” and partly on “noise”
The expected risk premium on a stock should depend on the expected risk premium associated with each factor and the stock’s sensitivity to each of the factors (b1, b2, b3)
What is the equation of the Arbitrage Pricing Theory?
In the abitrage pricing theory, what if the b’s are 0?
if the “b”s are 0, the expected risk premium is also 0.
-> A diversified portfolio that has 0 sensitivity to each macroeconomic factor is essentially risk-free return.
-> If the portfolio DID offer a higher return, you could make a risk-free profit (“arbitrage”) by borrowing to buy the portfolio.
What is the 1st step of carrying out the Arbitrage Pricing Theory?
- Start off by making a short list of macroeconomic factors that could affect stock returns
eg.
- market factor (return on market index minus risk-free interest rate)
- size factor (return on small-firm stocks less return on large-firm stocks)
- book-to-market factor (return on high book to market ratio stocks less return on low book-to-market stocks
What is the 2nd step of carrying out the Arbitrage Pricing Theory?
- Estimate the risk premium on each of these factors:
eg:
- market risk premium 7%
- difference between annual returns on small and large capitalization stocks avg 3.2%
- difference between the returns on stocks with high and low book-to-market ratios avg 4.9%
What is the 3rd step of carrying out the Arbitrage Pricing Theory?
Measure the sensitivity of each stock to the factors
and combine into final equation
