CAPM Flashcards
What are two ways we could maybe raise a Sharpe ratio of a portfolio?
You may be able to raise the Sharpe ratio of a portfolio by investing in an investment, I. You can either finance this by selling some of the risk free asset, or borrowing.
What will happen to the expected return and volatility of the portfolio when we add investment I?
The expected return will increase by E(ri) – rf when adding I to the portfolio
Regarding the volatility, we will add the risk that I has in common with the portfolio
When we add an investment to a portfolio, why do we only “add” it’s common risk with the portfolio?
When we add an investment to a portfolio, we only “add it’s common risk with the portfolio, as the rest of I’s risk will be negated by diversification
How is the incremental risk of the investment measured?
The incremental risk of the investment is measured by i’s volatility multiplied by it’s correlation with P, given by the equation SD(Ri)*Corr(Ri, RP)
The return from investing in I is greater than an extra investment in portfolio p if…
The return from investing in I is greater than an extra investment in portfolio p if the additional return from investment I is greater than the additional return from taking the same risk investing more in portfolio p.
If we increase the amount invested in security I, this will increase the … … of the portfolio if it’s …
If we increase the amount invested in I, this will increase the Sharpe Ratio of the portfolio if it’s expected return exceeds the required return given by portfolio P.
What is another name for the required rate of return?
Another name for the required rate of return is the internal rate of return
If the expected return is higher than the required rate of return, what do we do?
If the expected return is higher than the required rate of return, then we will keep investing in security I until it’s return correlated with the IRR of the portfolio, and we get the security
If we face no restrictions, we continue to trade until the … … of each security equals its … …
If we face no restrictions, we continue to trade until the expected return of the security equals its required return
What is the equilibrium condition for adding i to the portfolio, and what is the equation?
The equilibrium condition for adding I to the portfolio is that the expected return is equal to the required return
The equation for this is:
E(Ri) = ri = rf + Bieff * (E(Reff) – rf)
CAPM use the … choices investors make to identify the … portfolio and the … portfolio
CAPM uses the optimal choices investors make to identify the efficient portfolio and the market portfolio
What is the market portfolio?
The market portfolio is the portfolio of all stocks and securities in the market
Describe the three main assumptions of the CAPM model:
There are 3 main assumptions of the CAPM model:
Trading/borrowing: Investors can buy and sell all securities at competitive market prices, and borrow/lend at the risk-free interest rate
Efficiency: Investors only hold efficient portfolios of trade securities and portfolios that yield the maximum expected return for a given level of volatility
Expectations: investors have homogenous expectations regarding the volatilities, correlations, and expected returns of the securities
If investors have … expectations, they will all hold the … portfolio
If investors have homogenous expectations, they will all hold the market portfolio
What is the “Supply” of securities?
The supply of securities is the market portfolio
If a security is not part of the efficient portfolio, how does it become part of it?
If a security is not part of the efficient portfolio, it will be sold and it’s demand will fall and supply will increase, so it’s price will fall. When it’s price falls to a certain level, its expected return then rises, meaning it becomes part of the efficient portfolio
When CAPM assumptions hold, the market portfolio is …, so the tangent portfolio is actually the … portfolio
When CAPM assumptions hold, the market portfolio is efficient, so the tangent portfolio is actually the market portfolio
When the tangent portfolio is the … portfolio, the tangent line is called the … … …
When the tangent portfolio is the market portfolio, the tangent line is called the capital market line rather than the capital allocation line
Under CAPM assumptions, what is the security market line?
Under CAPM assumptions, the security market line is the line along which all individual securities should lie when plotted according to their return and beta
What is the horizontal difference between 0 volatility and the CML?
The horizontal difference between o volatility and the CML is the market risk of the portfolio
What is the slope of the CML?
The slope of the CML is the risk premium
What is the intercept of the CML?
The intercept of the CML is the risk free rate
What is/how do we get the beta of a portfolio?
The beta of a portfolio is it’s relative sensitivity to moves in the market, and we get it by dividing the covariance of a portfolio and the market by the volatility (Variance) of the market
If a stock is fairly priced, then what should it’s alpha be?
If a stock is fairly priced, its alpha should be zero, and it should be priced according to it’s market risk
What happens if a stock’s point on the SML graph is above or below the SML?
If a stock’s point on the SML graph is above or below the Security market line (SML), it’s price will drop or fall in future until it reaches the Security market line (SML)
Every portfolio on the efficient frontier has a … portfolio on the … … of the frontier
Every portfolio on the efficient frontier has a “companion” portfolio on the bottom half of the frontier
The companion portfolio is … with its counterpart
The companion portfolio is uncorrelated with its counterpart portfolio
When investors don’t have access to the risk free rate, where can they invest? (graphically)
When investors don’t have access to the risk free rate, they can invest on a point on the efficient frontier that suits their risk-return preferences
When there are borrowing restrictions, the market portfolio becomes…
When there are borrowing restrictions, the market portfolio becomes a combination of investors portfolios
In zero beta CAPM, instead of the risk-free rate we have the E(R) of…
In zero-beta CAPM, instead of the risk free rate we have the E(R) of the portfolio that has zero covariance with the market portfolio
When investors can’t borrow, what do they do?
When investors can’t borrow, they instead ‘tilt’ their portfolios towards high beta stocks and away from low beta ones
What is the intertemporal CAPM model?
The intertemporal CAPM model is the CAPM model that features multiple risk factors
What is the consumption based CAPM model?
The consumption based CAPM model incorporates non-traded assets such as labour or human capital
What is the Non-constant CAPM model?
The non-constant CAPM model is the model modified for liquidity risk
In the index model, excess stock returns are … distributed and driven by one … factor
In the index model, excess stock returns are normally distributed and driven by one systematic factor
Investors can … the non systematic risk
Investors can diversify the non-systematic risk
Selecting stocks with positive alpha can increase the … … on a portfolio
Selecting stocks with a positive alpha can increase the excess return on a portfolio
What happens if investors pursue positive alpha stocks?
If investors pursue positive alpha stocks, then they will drive up the prices of these stocks, lowering expected return, and reducing the alpha. The price of negative alpha stocks will then fall.
When all stocks have zero alpha, what is the market portfolio?
When all stocks have zero alpha, the market portfolio becomes the optimal risky portfolio
What are the two steps to use the market portfolio to estimate the expected return of a stock?
- Construct the market portfolio and determine it’s expected return over the risk free rate
- Estimate the stock’s beta to the market
In the market portfolio, what is the formula for the weights of each security?
In the market portfolio, the formula for the weights of each security are:
Market value of asset i / Total market value of all securities in the portfolio
What is a value weighted portfolio?
A value weighted portfolio is a portfolio where the proportion invested in each stock are decided by their market cap relative to the market size
What are some market index examples?
Some market index examples include:
FTSE 100, S&P 500, NASDAQ, Dow Jones index
What represents diversifiable risk on an excess return graph?
On an excess return graph, diversifiable risk is the deviation of a stock from the best-fitting line
What is the equation for estimating the beta of a security?
The equation for estimating the beta of a security is:
Rit – rft = ai + bi(Rmt – rft) + Eit
We can interpret alpha as a … … measure of a stock’s … …
We can interpret alpha as a risk-adjusted measure of the stock’s historical performance
Why is Beta not stable over time?
Beta is not stable over time because the dynamics of the stock change over time
How do we achieve the largest possible dispersion of beta coefficients for the second stage?
To achieve the largest possible dispersion of beta coefficients for the second stage, we first rank the stocks by betas and then group them into portfolios
