9. CAPM

Question 1

What is this topic all about?

Answer 1

Here, we’re using topic 7 (risk & return) to look at theories linking risk and return in a competitive economy & how to use them to estimate the returns required by investors in dif. stock market investments. (HOW TO CHOOSE THE OPTIMUM PORTFOLIO)
Most prominent theory is (CAPM) theory

Question 2

the distribution of a security’s returns follows a normal distribution

Answer 2

what does this mean?

only need to look at expected return & standard deviation,

Question 3

basic principle of portfolio selection

Answer 3

investors try to increase E(r) on their portfolios & reduce stdev of that return.
—> efficient portfolio: gives highest E(r) for given st dev or, lowest st dev for a given E(r).
To distinguish btw portfolios, must be able to state the E(r) & st dev of each stock + degree of correlation btw each pair of stocks.

investors restricted to common stocks should choose efficient portfolios that suit their attitudes to risk.

Question 4

For an investor who has only same opportunities (ie info) as everyone else they should invest

Answer 4

in the a mix of the market portfolio and a risk free loan (borrowing/lending).

Question 5

A stocks marginal contribution to portfolio risk is measured by

Answer 5

its sensitivity to changes in the portfolio’s value (beta)

Question 6

what is the fundamental idea of the Capital Asset Pricing Model

Answer 6

holds that the securities expected risk premium should increase in proportion to beta:(ie =beta* market risk premium).

Question 7

Diversification allows for a lower s.d. for every

Answer 7

level of return, and higher level of return for every level of s.d.

Question 8

how to choose an optimum portfolio

Answer 8

1. choose a Feasible portfolio with 2. minimum variance (offers the lowest risk at each level of E(R)) 3. which is efficient (offers the highest return for each level of risk)
   and 4. assume that rational investors hold efficient portfolios

Question 9

conclusion about portfolio theory

Answer 9

∟ Investors should only be facing market risk
∟ If investors are getting a higher return for higher risk, this extra risk incurred should
only be market risk
∟ Therefore: Higher market risk (not higher total risk) gives higher return

Question 10

sharpe ratio

Answer 10

Ratio of the risk premium:
(return on the portfolio – risk-free rate)/portfolio s.d
–> the min extra return required for taking on a higher risk

Question 11

what does the sharpe ratio measure

Answer 11

the level of return per unit risks but doesn’t tell us the optimum level of risk

Question 12

investors have 2 jobs:

Answer 12

1) selecting the best portfolio of common stocks (at tangency point)
2) blending the portfolio with borrowing or lending to obtain an exposure to risk that suits the particular investor’s taste.

Question 13

CAPM is derived from

Answer 13

Markowitz’s portfolio theory, not the same (labels on x axis differ)

Question 14

why is CAPM effective?

Answer 14

1. ease of use
2. assumes people will invest in a diversified portfolio similar to market portfolio
3. CAPM takes into account systematic risk (beta)

Question 15

disadvantages of CAPM

Answer 15

1. it’s only a 1 factor model, relying purely on the sensitivity of stock to market
2. Fama & french’s research indicated that stock size was a considerable factor (found that smaller firmsgave higher returns and bigger firms
   gave lower returns, a size and return relationship not explored by the CAPM)

Question 16

Alternative to CAPM: arbitrage pricing model

Answer 16

idea that an asset’s returns can be predicted using the linear relationship between the asset’s expected return and a number of macroeconomic variables that capture systematic risk.

good bc the market portfolio doesn’t feature, so no need to worry about measuring market portfolio, + in principle we can also test the arbitrage pricing theory even if we have data on only a sample of risky assets.

Question 17

Alternative to CAPM: 3 factor model

Answer 17

1. Identify a reasonably list of macroeconomic factors that could affect stock returns
   ∟ 2. Estimate the expected risk premium on each of these factors (rfactor1 − r1, etc.)
   ∟ 3.Measure the sensitivity of each stock to the factors (𝑏1 , 𝑏2 , etc.)

Question 18

Unlike the CAPM, which assume markets are perfectly efficient, APT assumes markets

Answer 18

sometimes misprice securities, before the market eventually corrects and securities move back to fair value.

Question 19

how do we describe the MPT curve (ie E(r) on y axis and standard deviation on x axis)

Answer 19

the feasible set of portfolios maps out a bullet-shaped curve, bounded at each end by the expected return & standard deviation of the individual securities. However, there are a number of feasible portfolios ( those to the left of the bottom boundary point) that have a lower st dev than either security as predicted by MPT. These aren’t efficient because they given the highest return from a given level of risk. Efficient portfolios are those that are represented from the minimum variance point running along the top to the feasible set to the right. These portfolios give the max return for the given level of risk