Asset Pricing Model Flashcards
CAPM
- It is the equilibrium model that underlies all modern financial theory
- Derived using principles of diversification with simplified assumptions
- Markowitz, Sharpe, Lintner and Mossin are researchers credited with its development
Assumptions are
• Individual investors are price takers
• Single-period investment horizon
• Investments are limited to traded financial assets
• No taxes and transaction costs
• Information is costless and available to all investors
• Investors are rational mean variance optimizers
• There are homogeneous expectations
Resulting equilibrium conditions are
• All investors will hold the same portfolio for risky assets – market portfolio
• Market portfolio contains all securities and the proportion of each security is its market value as a percentage of total market value
Return and Risk For Individual Securities
- The risk premium on individual securities is a function of the individual security’s contribution to the risk of the market portfolio.
- An individual security’s risk premium is a function of the covariance of returns with the assets that make up the market portfolio.
the CAPM Expected Return-Beta Relationship holds for overall portfolio (and for market istelf) because, Expected return and beta of portfolio is weighted average of individual assets in the portfolio
What are the implications of beta?
- Beta ‘better’ measure of risk than standard deviation when dealing with portfolio of assets: diversification removes much of individual assets Std dev
- Beta = 0, then asset not related to market portfolio (risk free asset return)
- Beta = 1, asset perfectly correlated with market portfolio (market return…neutral asset)
- Beta > 1 asset movements greater than market movement (> market return…aggressive asset)
- Beta < 1 asset movements less than market movement (< market return…defensive asset)
What is Security Market line?
A line that graphs the market, risk versus return of the whole market at a certain time and shows all risky marketable securities.
The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML.
The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security’s risk versus expected return is plotted above the SML, it is undervalued because the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued because the investor would be accepting less return for the amount of risk assumed.
What Capital Market line?
A line used in the capital asset pricing model to illustrate the rates of return for efficient portfolios depending on the risk-free rate of return and the level of risk (standard deviation) for a particular portfolio.
Investopedia explains ‘Capital Market Line - CML’
The CML is derived by drawing a tangent line from the intercept point on the efficient frontier to the point where the expected return equals the risk-free rate of return.
The CML is considered to be superior to the efficient frontier since it takes into account the inclusion of a risk-free asset in the portfolio. The capital asset pricing model (CAPM) demonstrates that the market portfolio is essentially the efficient frontier. This is achieved visually through the security market line (SML).
Is the CAPM Practical?
• CAPM is the best model to explain returns on risky assets. This means:
– Without security analysis, α is assumed to be zero.
– Positive and negative alphas are revealed only by superior security analysis.
- We must use a proxy for the market portfolio.
- CAPM is still considered the best available description of security pricing and is widely accepted.
What are the examples of extensions to CAPM?
- Merton’s Multiperiod Model and hedge portfolios
- Incorporation of the effects of changes in the real rate of interest and inflation
- Consumption-based CAPM
- Rubinstein, Lucas, and Breeden
- Investors allocate wealth between consumption today and investment for the future
Liquidity Risk
It is the ease and speed with which an asset can be sold at fair market value.
In a financial crisis, liquidity can unexpectedly dry up. When liquidity in one stock decreases, it tends to decrease in other stocks at the same time. Investors demand compensation for liquidity risk
Illiquidity Premium: Discount from fair market value the seller must accept to obtain a quick sale.
– Measured partly by bid-asked spread
– As trading costs are higher, the illiquidity discount will be greater.
Single Factor Model
n/a
