Capital Asset Pricing Model (CAPM) Flashcards
Why is the Capital Market Line not sufficient?
CML tells expected return of a portfolio
–> does not tell how to price a single risky asset held as part of a well diversified portfolio
–> part of total risk is diversified away in a portfolio, so Standard Deviation is not a good measure of risk
Assumptions of the CAPM
- Individual behavior
–> Investors are rational
–> planning period is one single period
–> homogeneous expectations (all relevant information is publicly available) - Market Structure
–> all assets are publicly trade
–> possibility of trading at a risk-free rate and short positions
–> no taxes
–> no transaction costs
decomposition of Standard Deviation
company risk –> risk that can be diversified away
market risk (beta) –> risk that cannot be diversified away
CAPM only considers market risk (beta)
What is beta a measure of?
measures market risk
–> how an individual risky asset co-varies with the market
–> a stock’s sensitivity against the market
overall market beta = 1
beta > 1 –> security is more volatile than the overall market
beta < 1 –> security is less volatile than the overall market
What does a beta of 0,45 signify?
If the market goes up 1%, the stock will go up 0,45%
If the market goes down 1%, the stock will go down 0,45%
interpreting beta
a stock’s beta shows how sensitive its underlying revenue and cash flows are to general economic conditions
–> beta is the expected percent change in excess return of a security for a 1% change in the excess return of the market portfolio
difference between beta and volatility
volatility measures total risk (systematic risk + unsystematic risk)
beta measures only systematic risk
How to measure systematic risk?
Determining how much of the variability of a stock’s return is due to systematic risk vs. unsystematic risk
–> average change in the return for each 1% change in the return of a portfolio that fluctuates only due to systematic risk (efficient portfolio, e.g. market portfolio)
Security Market Line (SML)
shows the “correct” price of the assets
–> when security returns are plotted with beta used as a measure of risk
In an efficient market, where should all securities be plotted?
In an efficient market, all securities should plot along the Security Market Line
–> if a security plots above SML –> price is too low and return too high for the risk assumed (undervalued)
–> if a security plots below the SML –> price is too high and return too low for the risk assumed (overvalued)
Where does an undervalued stock plot in CAPM?
undervalued = price too low and return too high for the risk assumed
–> above the SML
Where does an overvalued stock plot in CAPM?
overvalued = price too high and return too low for the risk assumed
–> below the SML
slope of the Security Market Line
y-Achsenabschnitt = expected return of risk free asset
- Punkt zum verbinden = beta 1 and expected return of market
Negative beta stocks
expected return of the stock with a negative beta will be below the risk free rate
–> stock will tend to rise when the market and most other securities fall, so the stock can be a “recession insurance”
the risk premium for diversifiable risk is
zero (0)
if you can diversify a risk away with a good portfolio, then you would get a reward for no additional risk, thats why there is no risk premium for company risks, only for market risks
