Capital Asset Pricing Model (CAPM) Flashcards
What are the assumptions underlying the capital asset pricing model?
1). All investors have identical (or homogeneous) expectations with respect to expected returns, standard deviations, and correlation coefficients for all available individual securities.
2). All investors have the same one-period time horizon.
3). All investors can borrow or lend money at the risk-free rate of return (RF).
4). There are no transactions costs.
5). There are no personal income taxes so that investors are indifferent between capital gains and dividends.
6). There are many investors, and no single investor can affect the price of a stock through their buying and selling decisions. Therefore, investors are price-takers.
7). Capital markets are in equilibrium.
How do you determine if an asset is undervalued correctly valued or overvalued?
A portfolio or security is correctly valued when the required rate of return is equal to the expected return. The portfolio or security is undervalued (too cheap) when the required rate of return is lower than the expected rate, and is overvalued when the required rate is higher than the expected rate of return.
SO all about RRR=ER
If a security’s total risk (variance) increases, does that mean the beta must have increased? Explain.
No, the total risk has two components – systematic (or market) and unique (non-systematic). If the total has increased, it doesn’t mean that the market risk (measured by beta) component has necessarily increased.
What would motivate an investor to invest in a stock whose beta is negative, implying its expected return is less than the risk-free rate?
A savvy investor recognizes that negative beta stocks can only occur if the security is negatively correlated with the overall market, which is uncommon. By investing in this stock, they would likely be able to reduce the overall risk of their portfolio.
State Roll’s critique concerning the CAPM.
Roll argued that the CAPM cannot be tested empirically because the market portfolio, which consists of all risky assets, is unobservable. This forces researchers to use market proxies, which may or may not be the optimal mean-variance efficient portfolio. He also argues that tests of the CAPM are actually tests of the mean-variance efficiency of the chosen market portfolio. He shows that the basic CAPM results will hold whenever the chosen proxy is mean-variance efficient, and will not hold if the converse is true.
Example of question:
Your client is confused. He owns shares in Whistler Snow-Making Company (WSMC) and wants you to explain your recommendation. Both of you agree on the following: WSMC has an expected return of 12 percent, a standard deviation of 9 percent, and a beta of 1.25; the expected return on the market is 8 percent, with standard deviation of 3 percent; and the risk-free rate is 4 percent.
Your client has a basic understanding of the CAPM and, based on the capital market line, feels he should sell the stock. However, you are recommending that he buy more of the stock (or at least hold what he has). Explain your recommendation to your client
The client does not understand the difference between the Capital Market Line (CML) and the Security Market Line (SML). The CML represents the relationship between the expected return and risk for efficient portfolios while the SML plots the relationship between the returns of individual securities and the market risk (Beta).
CML cannot be used to value individual securities because individual securities are not efficient portfolios; an efficient portfolio will be a well-diversified portfolio and thereby have relatively little unique risk. A security, in contrast, will potentially have a great deal of idiosyncratic risk. Consequently, as only the market risk is priced (investors receive a reward for accepting this risk), we value securities using the SML.
This security has a lot of idiosyncratic risk, but, as long as the client holds a well-diversified portfolio, he can remove the effects of this risk and be left with just the market risk. The required return for a stock with this level of market risk is 9 percent (i.e., k = 4 + (8-4)(1.25) = 9%; however, you are expecting to earn 12 percent by holding the stock. Therefore, buy the stock. In contrast, if we used the CML, we would determine a required return of 16 percent (i.e., k = 4 + (8-4)(9/3) = 16%), which would suggest the stock is overvalued if the expected return is only 12 percent.
