8.2 Capital Market Theory

Question 1

Capital Asset Pricing Model (CAPM)

Answer 1

CAPM does not consider unsystematic risk

The market risk premium is the incentive required for the individual to invest in the securities market

The stock risk premium is the inducement necessary to entice the individual to invest in a particular stock.

Question 2

Asset Pricing Models

Answer 2

The capital asset pricing model (CAPM) shows a linear relationship between risk and return.

The capital asset pricing model (CAPM) suggests that the only factor that explains returns is a stock’s beta.

The arbitrage pricing theory (APT) suggests that the relationship between a stock’s risk and return is not linear.

Question 3

Arbitrage Pricing Theory

Answer 3

An investor using the APT starts with a required return for a security, possibly computed using the CAPM. The investor then adjusts the required return for a multitude of factors that may affect that particular security, such as interest rates, industrial production, and inflation.

Question 4

Expected Return

Answer 4

Expected return is what determines an asset’s value. The expected return must be greater than the investor’s required return to induce the investor to make the investment. Historical return is only important to the extent that it may impact future return

Question 5

capital market theory

Answer 5

The market risk premium is the difference between the expected return for the equities market and the risk-free rate of return.

The security market line (SML) depicts the trade-off between risk and expected return for all assets, whether individual securities, inefficient portfolios, or efficient portfolios.

The security market line (SML) is the graphical depiction of the capital asset pricing model (CAPM).

Question 6

The security market line (SML)

Answer 6

Shows a security’s expected return as a function of its systematic risk

Question 7

Capital Asset Pricing Model (CAPM)

Answer 7

Systematic risk is the relevant risk in a diversified portfolio under the CAPM.

CAPM determines the investor’s required rate of return for a given risky investment

Question 8

Assets with expected returns that lie above the security market line (SML)

Answer 8

Are undervalued. Assets that lie above the security market line (SML) are undervalued because their expected returns are higher than the required return represented by the SML.