Asset Pricing Models Flashcards
What is the cost of capital?
Rate of return that the providers of capital require in order to contribute their capital to the firm
What does Beta measure? How is it defined?
Sensitivity of the asset’s return to the market return. It is defined as the expected percent change in an asset’s return given a 1% change in the market return
What is the average beta?
1
What types of industries tend to have higher and lower betas?
Cyclical industries (tech, luxury goods) tend to have higher betas. Non-cyclical industries (utility, pharmaceutical) tend to have lower betas
Interpret Beta = 1, beta < 1, beta > 1, beta = 0
Beta = 1 : The asset has the same systematic risk as the market
beta > 1 : the asset has more systematic risk than the market (the asset will go up and down more than the market in %)
beta < 1 : the asset has less systematic risk than the market (the asset will go up and down less than the market in %)
beta = 0 : the asset’s return is uncorrelated with the market return
TRUE or FALSE : E[R_i] in CAPM is influenced by nonsystematic risk
FALSE. Beta only captures systematic risk
Name the assumptions of CAPM. What is the consequence of these assumptions.
- Investors can buy and sell all securities at competitive market prices. There are no taxes or transaction cost. Investors can borrow and lend at a risk free interest rate
- Investors hold efficient portfolios of traded securities
- Investors have homogeneous expectations regarding the volatilities, correlations and expected returns of securities
Consequence : the market portfolio is the efficient portfolio
Name 2 differences between CML and SML
- for CML, the x axis is based on total risk (volatility). For SML, the x axis is bases on systematic risk (beta)
- CML only holds for efficient portfolios, bc any combination of risk-free asset and market portfolio is efficient. SML holds for any security, bc CAPM can be used to calculate the expected return for any security.
What is alpha? What happens if the market portfolio is efficient?
The difference between a security’s expected return and the required return (as predicted by the CAPM). If the market portfolio is efficient, all securities are on SML, and alpha = 0.
How can investors improve the market portfolio (regarding alpha)
Buy stock whose alpha > 0, sell stocks whose alpha < 0.
In what case will a new investment increase the Sharpe ratio of a portfolio?
If its expected return exceeds its required return
What are the two methods to estimate the market risk premium?
- Historical risk premium ( uses the historical average excess return of the market over the risk-free interest rate) and
- fundamental approach ( Uses the constant expected growth model to estimate the market portfolio’s expected return) E[R_Mkt] = (Div_1)/P_0 + g
What are the two methods to estimate the debt cost of capital?
1.Adjustment from debt yield : r_d = yield to mat. - P(default)*E[Loss rate]
2.CAPM using debt betas
r_d = r_f + beta_d [E[R_Mkt] - r_f]
What are the characteristics of debt betas
They tend to be low. The debt for beta increases as the credit ranking decreases
What is a firm’s entreprise value
The risk of the firm’s underlying business operations that is separate from its cash holdings. It is the combined market value of the firm’s equity and debt, less any excess cash
V = E + D - C
