Capital Asset Pricing Model Flashcards
What are the assumptions of the Capital Asset Pricing Model?
1) Many small investors that are price takers
2) Identical holding period
3) Only tradable securities (stocks, bonds and risk-free)
4) No taxes or transaction costs
5) All investors are rational, so they can choose efficient portfolios
6) Homogeneous expectations and beliefs (same information set)
True or false: in the CAPM the securities are tradable (stocks, bonds and risk free)
True
What does the Security Market Line tell us?
Given an efficient portfolio, the SML gives us the equilibrium expected return of any securite/portfolio.
What is the market risk premium?
E(rm) - rf
What is the risk premium for a security?
β * (E(rm) - rf)
What is the risk premium on any security/portfolio equal to?
The risk premium on any security/portfolio is equal to its exposure to market (systematic) risk (β) times the market risk premium.
What is the expected excess return on any security/portfolio equal to?
The risk premium on any security/portfolio is equal to its exposure to market (systematic) risk (β) times the market risk premium.
What is the expected excess return?
The risk premium.
What does β measure?
β measures the relationship between what you’re adding and the market. It captures the systematic risk.
What is the β for the market?
1
What does it mean when β<1?
The portfolio has less systematic risk than the market portfolio.
When should markets provide you with a premium?
If it has idiosyncratic risk, markets shouldn’t compensate you for risk you can eliminate.
What does the risk premium of a security/portfolio depend on?
How it is impacted by systematic risk (can’t be eliminated).
How can we separate the total risk of a given stock?
We need to use a portfolio that only contains systematic risk, which is the market portfolio.
True or false: the market portfolio exists in real life.
False
What do we use to get a proxy for the market portfolio?
Large indexes of stocks, such as S&P 500 or Nasdaq.
What does it mean when βi > 1?
The equilibrium expected return is higher than the expected return of the market, which means the portfolio is high risk.
What does it mean when βi = 1?
The equilibrium expected return is the expected return of the market portfolio, which means it’s the market portfolio.
What does it mean when 0 < βi < 1?
The equilibrium expected return is between the return of the risk free asset and the expected return of the market, which means it’s a low risk security.
What does it mean when βi = 0?
It’s the risk free asset.
What does it mean when βi < 0?
The equilibrium expected return is lower than the return of the risk free asset, which means stock i offers insurance.
If the equilibrium expected return is lower than the return of the risk free asset, what does that say about βi?
βi is lower than 0.
If the equilibrium expected return is between the return of the risk free asset and the expected return of the market, what does that say about βi?
βi is between 0 and 1.
If the equilibrium expected return is the expected return of the market, what does that say about βi?
βi is 1 (market portfolio)
If the equilibrium expected return is higher than the expected return of the market, what does that say about βi?
βi is higher than 1.
In the CAPM, what happens when markets are in equilibrium?
Investors receive the same as the equilibrium expected return.
What is the difference between the Capital Market Line and the Security Market Line?
While the CML is a graphical representation on all efficient portfolios (combines market portfolio with the risk free asset), the SML is a graphical representation on all equilibrium returns on individual securities and portfolios (being the portfolios efficient or not).
True or false: the portfolios on the SML are all efficient.
False
True or false: the portfolios on the CML are all efficient.
True
When is a security not in equilibrium?
When the equilibrium return from the SML is different from the return expected by investors.
True or false: A is undervalued if the return expected by investors is higher than the equilibrium return.
True
True or false: A is overvalued if the return expected by investors is higher than the equilibrium return.
False
True or false: A is overvalued if the return expected by investors is lower than the equilibrium return.
True
True or false: A is undervalued if the return expected by investors is lower than the equilibrium return.
False
True or false: when a security is undervalued, we should sell it.
False
True or false: when a security is undervalued, we should buy it.
True
True or false: when a security is overvalued, we should sell it.
True
True or false: when a security is overvalued, we should buy it.
False
When should we sell a security?
When it is overvalued, meaning the return expected by investors is lower than the equilibrium return.
When should we buy a security?
When it is undervalued, meaning the return expected by investors is higher than the equilibrium return.
What is a portfolio’s β?
The weighted average β of the securities in the portfolio.
True or false: According to the CAPM theory, investors should be compensated with higher returns when faced with more risk.
False. According to the CAPM theory investors should be compensated with higher returns when faced with a higher beta. Beta is a measure of systematic risk. Therefore, investors should not be compensated when faced with higher levels of idiosyncratic risk. This so because investors can diversify their portfolios and eliminate idiosyncratic risks.
True or false: According to the CAPM theory, a security is undervalued when investors expect a return higher than the equilibrium return.
True. According to the CAPM model we expect the return expected by investors to converge to the equilibrium return. In this case, the return expected by investors must decrease. For this return to decrease the security’s price must increase. This implies that the price is too low and therefore the security is undervalued.
True or false: Consider two securities with the same standard deviation. Based on the CAPM theory, both securities should have the same beta (same systematic risk).
False
True or false: Consider the CML. If you plug in that expression the standard deviation of stock X, you will achieve the highest possible expected return for that level of standard deviation (risk) in a given economy.
True
