Capital asset pricing model (CAPM)

Question 1

CAPM model

Answer 1

Formula which expresses the expected return of an asset to it’s sytematic risk (market risk).

Market risk is represented by beta.

Question 2

Security Market Line (SML)

Answer 2

The SML graphically represents the expected return of an asset based on its beta. It shows that higher risk (beta) requires a higher return.

Question 3

Tangent portfolio

Answer 3

The tangent portfolio is the portfolio that maximizes the Sharpe ratio, combining risky assets and possibly a risk-free asset.

Question 4

Zero coupon bond?

Answer 4

A zero-coupon bond is a bond that doesn’t pay periodic interest (or coupons) but instead pays its face value (e.g., $100) at maturity.
The price of a zero-coupon bond today depends on the interest rate and the time until maturity. The longer the maturity, the lower the bond’s price for the same face value.

Question 5

Law of one price?

Answer 5

The law of one price states that two assets with identical cash flows must have the same price in an efficient market.

If they don’t, arbitrage opportunities arise, allowing investors to earn risk-free profits by buying the cheaper asset and selling the more expensive one.

Question 6

Mean-Variance Frontier

Answer 6

This is the set of portfolios that offer the highest expected return for a given level of risk. It includes all efficient portfolios, where adding any other asset would not increase return without increasing risk. In other words, it represents the best trade-off between risk and return.