9 CAPM and SML

Question 1

Explain Ei=Rf+(Em-Rf)βi

Answer 1

Return of a risky asset is equal to at least the return of the risk free
Plus the expected returns of the market above that risk free rate times by the correlation of the security to the market

Question 2

What is the beta for the market portfolio

Answer 2

1

Question 3

What is an aggressive beta

Answer 3

When beta > 1

Question 4

What is a defensive beta?

Answer 4

When 0 < beta < 1

Question 5

What is Beta

Answer 5

Volatility of a securities returns relative to the market portfolio
Is return for systematic risk as unsystematic has been diversified away

Question 6

How do companies use capital budgeting?

Answer 6

Ek>Rf+(Em-Rf)βi (then accept)
Considers the amount of return in relation to risk exposed to
Ek is the required rate of return and compared to company’s FCs

Question 7

What can be interpreted about an investment on the SML

Answer 7

It is correctly priced
Given the level of risk
Companies should invest here

Question 8

What can be interpreted about an investment above the SML

Answer 8

Under priced for level of risk
Market would see them demand it, pushing up price which reduces return
If possible companies should invest here

Question 9

What can be interpreted about an investment below the SML

Answer 9

Over priced for level of risk
Should not be invested in

Question 10

SML and mutually exclusive projects
“What to do if SML says to invest in two projects but mutually exclusive?”

Answer 10

If they have the same outlay see which gives greatest excess returns

If different outlay find the NPV for level of risk

Question 11

What is the beta of a risk free security

Answer 11

0

Question 12

What is a negative beta

Answer 12

When an asset moves inversely to the market
Good hedge in recession
Has a low return as as when everyone wants to hedge against a downturn it drives up price and keeps the returns low

Question 13

What does an investment with beta 1 that is not the market portfolio have

Answer 13

Systematic risk

Question 14

How do you find beta

Answer 14

Plot returns of market against returns of security
The do a slop of best fit, this is the Security Characteristic Line (SCL)
Most rating agencies then apply their own assumptions

Question 15

Issues with Security Characteristic Line (SCL)

Answer 15

Only looks at historic data and the stock market pricing is based on future returns
Not knowing how far back to go and set the time horizon or the company has only just listed

Question 16

Would you ever select under the SML

Answer 16

Buying A alone would leave you undiversified and with an inferior return.
Adding it to a diversified portfolio would cure the lack of diversification but not the inferior return. If you want a portfolio with a beta of 0.5, you could get a higher expected return by investing half your money in Treasury bills and half in the market portfolio. If everyone shares your view of the stock’s prospects, the price of A will have to fall, increasing the expected return until it matches what you can get on the security market line.

Question 17

Would you ever select over the SML

Answer 17

Would you be tempted by its high return? You shouldn’t be. You could get a higher expected return for the same beta by borrowing 50 cents for every dollar of your own money and investing 1.5 times your initial wealth in the market portfolio. B has an inferior return, so no investor would want to buy it on its own or add it to a diversified portfolio. Thus, the price of stock B cannot hold. It will have to fall until the expected return on B rises to equal the expected return on the combination of borrowing and the market portfolio that has the same beta as B.