9. CAPM Flashcards
What is this topic all about?
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
the distribution of a security’s returns follows a normal distribution
what does this mean?
only need to look at expected return & standard deviation,
basic principle of portfolio selection
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.
For an investor who has only same opportunities (ie info) as everyone else they should invest
in the a mix of the market portfolio and a risk free loan (borrowing/lending).
A stocks marginal contribution to portfolio risk is measured by
its sensitivity to changes in the portfolio’s value (beta)
what is the fundamental idea of the Capital Asset Pricing Model
holds that the securities expected risk premium should increase in proportion to beta:(ie =beta* market risk premium).
Diversification allows for a lower s.d. for every
level of return, and higher level of return for every level of s.d.
how to choose an optimum portfolio
- 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
conclusion about portfolio theory
∟ 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
sharpe ratio
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
what does the sharpe ratio measure
the level of return per unit risks but doesn’t tell us the optimum level of risk
investors have 2 jobs:
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.
CAPM is derived from
Markowitz’s portfolio theory, not the same (labels on x axis differ)
why is CAPM effective?
- ease of use
- assumes people will invest in a diversified portfolio similar to market portfolio
- CAPM takes into account systematic risk (beta)
disadvantages of CAPM
- it’s only a 1 factor model, relying purely on the sensitivity of stock to market
- 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)
Alternative to CAPM: arbitrage pricing model
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.
Alternative to CAPM: 3 factor model
- 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.)
Unlike the CAPM, which assume markets are perfectly efficient, APT assumes markets
sometimes misprice securities, before the market eventually corrects and securities move back to fair value.
how do we describe the MPT curve (ie E(r) on y axis and standard deviation on x axis)
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
