Capital Asset Pricing Model

Question 1

how can you achieve a higher average long run rate of return in a portfolio

Answer 1

have to increase the risk level of the portfolio that cant be diversified away

MARKET DOESNT OFFER PREMIUMS FOR RISKS THAT CAN BE DIVERSIFIED AWAY

• if it can be diversified away then there is no premium for bearing these risks

Question 2

what is Total risk =

Answer 2

systematic risk + unsystematic risk

Question 3

what is systematic risk

Answer 3

you cant diversify

• basic variability of stock prices
• about the economy
• aggregate risk
• all assets move together

Question 4

what is unsystematic risk

Answer 4

can be diversified away

• affects only particular companies
• diversifying helps reduce risk because investing in a lot of assets = get the average return

no premium for this risk

Question 5

what is Beta

Answer 5

measure of market risk
B= 1
- broad market index

so if a stock has B = 2 then swings twice as much as market portfolio does

Question 6

a high beta has a high …

Answer 6

high risk premium
- investor has to be compensated for the high risk stock

Question 7

what is the capital asset pricing model?

Answer 7

It provides a framework for estimating the appropriate required return on an investment by taking into consideration the risk-free rate of return, the expected market return, and the beta coefficient of the investment.

Question 8

what are the assumptions of the capital asset pricing model?
4

Answer 8

1. asset markets are in equilibrium
   - prices are always equilibrium prices - markets clear fast
   - frictionless - no transaction costs - investors can borrow and lend unlimited amount at risk free rate - assets are divisible - investors are price takers
2. mean variance objective function
   - investors only care about risk and return
3. homogenous beliefs about expected returns, variances and covariances
   - everyone has the same efficient frontier
   - same line, curve and tangency
   - the differences between everyone is their preferences in the proportions they will invest in risk free and risky
4. single period investment horizon

Question 9

from the formula what does a B=2 imply

what is B = 1

Answer 9

for LHS and RHS to be equal - the risk premium of the asset has to be twice the risk premium of the portfolio

wont make a difference at all - wont change the risk premiums

Question 10

what is assumption of Bjz

Answer 10

it is the same across investors for every asset j
Zj is the same across investors for every asset j (proportion invested in risky asset j)

everyone has the same efficient frontier
you will invest in same risky portfolio

Question 11

how is the proportion of risky asset j determined in the risky asset portfolio

Answer 11

same zj for each investor

is equal to the share of the market value of asset j in the total market value of all risky assets

the total value of google = total investment in google (zjbi)

Question 12

what does the capital market line show?

Answer 12

shows combinations of portfolio risk and return that are compatible with equilibrium

Question 13

what does the security market line show

Answer 13

shows combinations of security risk and return that are compatible with equilibrium

Question 14

CML in absence of riskless asset

Answer 14

everyone has same beliefs = homogeneity

everyone has same frontier for all investors

Question 15

CML with risky asset and risk free asset

Answer 15

the capital market line depicts this

Question 16

how do you derive the CML capital market line

Answer 16

• combine investment is riskless asset with investment in market portfolio
• correlation coefficient between returns of market portfolio and any other efficient portfolio = +1

Question 17

show graphically and interpret CML line

Answer 17

graphical representation of the risk return tradeoff for a portfolio that includes risk free asset and a risky portfolio

slope = how much additional return an investor can expect for taking on additional risk = ratio of the 2 risks

intersect between CML and efficient frontier = optimal risky portfolio that offers highest return for a given level of risk

Question 18

what does efficient frontier show

Answer 18

curve that represents all efficient portfolios with the maximum expected return for a given level of risk

Question 19

what does anything lying on CML represent

Answer 19

combo of risk free asset and the optimal risky portfolio

Question 20

what does the security market line do

Answer 20

finding the equilibrium risk/return trade off for every asset

Question 21

how is disequilibrium of the market shown in SML
- if A is above the SML

Answer 21

• A has a high return
• investors will buy
• demand increases for A so price increases
• increase in P = drops the return - A adjusts back to the line

Question 22

how is disequilibrium of the market shown in SML
- if B is below the SML line

Answer 22

• relative to risk B has a low return
• everyone sells
• no one buys
• price decreases
• expected payoff increases
• immediate adjustments means market is efficient

Question 23

how do you get price from SML equation

Answer 23

convert Uj to percentage change
E[vj]-pj / pj = r0 +OBj
rearrange to get pj

Question 24

what does the difference between perfect certainty and case with uncertainty

Answer 24

uncertainty = depending on Bj - how much the assets risk constributes to market risk - if it is a risky asset you have to be compensated - you are willing to pay a smaller price