Asset Pricing Models Flashcards
Modern Portfolio Theory invented by who
Harry Markowitz 1954
Modern Portfolio Theory does what
quantifies the relationship between different risky asset classes using asset class average mean return, risk, and correlations between each set of asset class
What is a risky asset re: Modern Portfolio Theory
an investment whose returns vary - vs a non-risky asset like a T-bill whose returns are fixed
Modern Portfolio Theory uses standard deviation or beta?
Standard Deviation
Driving assumptions of Modern Portfolio Theory
-investors are rational/risk averse
-demand to be compensated for risk
-will combine asset classes which collectively will produce the highest possible average return per unit of risk
Efficient Frontier Portfolio produces what
highest possible return for unit of risk
Efficient frontier portfolios represent
mean-variance optimized efficient portfolios
Combining asset classes together can produce what re: risk
can produce a lower risk portfolio than either class individually
A portfolio below the efficient frontier offers what
inefficient - offers a lower return for the level of risk
Can you obtain a portfolio above the efficient frontier?
no
Can an individual investor have more than one efficient portfolio
No
Capital market line assumes investors invest in what
risky and non-risky assets
Capital market Line assumes there are how many optimal portfolios
only one
Capital Market Line Optimal Portfolio is called
Market portfolio -
How can you change your risk/return using Capital Market Line
change the ratio of market portfolio and non-risky assets
Capital market line uses beta or standard deviation
standard deviation
Capital Market Line invented by whom
James Tobin 1958
Unsystematic Risk also called what
Alpha
Systematic risk also called what
Beta
Can you reduce systematic risk/Beta with diversification?
No
Can you reduce unsystematic risk/Alpha through diversification?
Yes - to near zero
Who invented security market line?
William Sharpe in 1964
Security Market Line says what re: stock portfolio’s total risk can be broken down how
Can be broken down into 2 parts - Unsystematic risk, or Alpha AND Systematic risk or Beta. You can reduce Alpha/Unsystematic risk through diversification
Sharpe postulated that since alpha can be reduced to near zero by diversification
that the only relevant risk is Beta/Systematic risk
CAPM tells you what
the amount of return the security must earn (required return) in order to fairly compensate for the risk taken
Required rate of return is used in what 2 methods?
CAPM and Dividend Growth Model
CAPM and SML are used for individual securities or portfolio?
Individual
What is this formula
Ri = Rf + (Rm - Rf)Bs
CAPM/SML
Is CAPM the same thing as SML?
Yes
Stocks Dividend 5 years ago was 1.49. Current dividend is 1.90. What is the growth rate?
N = 5
PV = 1.49 CHS
PMT = 0
FV = 1.90
Solve for I
I = 4.98 or 5%
What is this formula
r = D1/Po + g
Expected return
Price = 48
Dividend 5 years ago = 1.49
Current dividend = 1.90
Rf = 4%
Rm = 9 (expected market return)
Bs = 1.1
Find the stocks expected return
First figure out the growth rate
N = 5
PV = 1.49 CHS
PMT = 0
FV = 1.90
Solve for I
I = 4.98 or 5%
THEN use expected return formula - Take Current Dividend * g
1.90 * 1.05 = 2
2/48 + .05 = 9.2% expected return
What is this formula
Rs = Rf + Bs(Rm - Rf)
Required return
CAPM relies on 2 variables what are they
Beta and market risk premium
Arbitrage Pricing Theory says what about risk
return on a stock or portfolio is not based just on Beta and Market risk but also
-Inflation
-Industrial Output
-Risk Premiums (Rm-Rf) & Beta
-Interest Rates
Focus of APT regarding systematic variables
unexpected changes to systematic variables
What is arbitrage
Buying in one market and simultaneously selling in another market to take advantage of price differentials
Arbitrage assures what regarding price
that there is only one price - if there is a difference traders will arbitrage it away until there is only one price
Is strong form Efficient market theory supported by empirical evidence?
No
Strong form EMT says what regarding insider information
it won’t help - it’s already priced in - this is not necessarily true
Semi strong EMT say what re: insider info
insider info would boost returns - this is backed by empirical evidence
Semi strong EMT says what regarding fundamental analysis?
It does not help boost returns because it is available to everyone in the market
Weak form EMT says what about insider info and fundamental analysis?
They both work but technical analysis does not work
What makes markets efficient?
-many competing participants
-information is random (not known in advance) and readily available
-price react instantaneously to new information
-transaction costs are small
Are there anomalies to EMT?
Yes but not supported by empirical evidence such as
-Low p/e stocks
-small firms
-investing in January
-firms not widely covered
All tend to perform well
Individual Investors tend to perform how relative to the S&P 500
Realize about 1/3 of the returns of S&P 500 while taking more risk
Object of Behavioral Finance
to overcome our emotions so we can act more rationally in our investment decisions
Study showing individuals realized 1/3 of the returns of S&P 500
Dalbar in 2007
Can you have negative Beta?
Yes. Beta can be positive, zero, or negative.
Jensen and Treynor ratios assume what type of portfolio, diversified or non-diversified?
Diversified
Per MPT the optimal portfolio is located at the point of tangency between the efficient frontier and the what
indifference curve
Operating profit margin ebit rhymes with profit
ebit
——-
sales
