Capital Asset Pricing Model

Question 1

What are the assumptions of the CAPM?

Answer 1

1) No transaction costs
2) No Taxes
3) Individuals can’t affect price levels
4) Decisions are made on expected values and the S.D of returns
5) Stocks are infinitely divisible
6) Homogenous Expectations
7) Risk-Averse Individuals

Question 2

Why might T-bills not be considered as ‘risk-free’? and what are the consequences of this on the ‘risk-free rate’?

Answer 2

Inflation risk - real value can fall. Risk-free rate isn’t constant

Question 3

What does the security market line describe? And what is the significance of beta

Answer 3

The return from the i’th security. Beta is stock i’s market risk, i.e how sensitive it is to market market movements.

Question 4

Why does Beta determine Portfolio risk?

Answer 4

In a very well diversified portfolio, there is only market risk, Beta captures the relative risk of portfolio compared to market risk.

Question 5

What 3 ratios can be used to to measure risk-adjusted performance?

Answer 5

1) Sharpe Ratio (higher the better, total risk)
2) Treynor Ratio (higher the better, market risk)
3) Jensen’s Alpha (higher the better, relative to CAPM estimates)

Question 6

What is the Empirical evidence for the CAPM?

Answer 6

1) Positive linear relationship between past returns and Beta
2) Controls that represent unsystematic risk doesn’t improve model fit
3) Low beta stocks perform greater than CAPM predicts and high beta stocks perform weaker than CAPM predicts
4) Intercept is greater than theory

Question 7

What is Roll’s critique of the CAPM?

Answer 7

CAPM can’t be fully tested as systematic risk is measured relative to the market proxied with the S&P500. The distortion of using national stocks has risen over time due to international diversification.

Question 8

Why did Fama and French publish a paper named “The Death of Beta”?

Answer 8

Beta cannot fully explain a stock’s relative performance over time. Others such as: firm size, ratio of book to market value work better.

Question 9

What are the strengths of the CAPM?

Answer 9

1) Theoretically elegant way to think about markets
2) Emphasises the impact of market risk on expected returns
3) Assumes market returns relate only to market index, other determinants are diversifiable, so it is simple

Question 10

What are the weaknesses of the CAPM?

Answer 10

1) Too simple
2) Values must be pre-assigned i.e. risk free rate of return (which isn’t constant)
3) Additional information is required