CAPM Flashcards
What are the key problems of the CAPM
In reality the risk-free return is NOT always available. To counter this, the return on government treasury bills are used
Betas are based on past performance which is not a perfect measure, which questions is suitability overall as measure for future risk.
A study of US securities showed that their actual returns bore no relation to CAPM.
Furthermore, studies seem to suggest that both systematic and unsystematic risk are being valued in the market
What do you use for the market portfolio to produce the market return in the CAPM?
A market index (e.g. FTSE 100) is usually used to represent the CAPM market portfolio. This can affect the level of Beta as different market indices have different Beta’s and therefore brings into question it’s accuracy if the correct representation of the market is not used.
The CAPM model necessarily makes a number of assumptions?
►All investments have the same term (holding period)
► Risk is the only factor in the investor making investment decisions and that investors are rational!
► There are no liquidity problems, there are many buyers and sellers in the market and so it will always be possible to find a willing buyer without delay. No one individual can
affect the price of the market.
► Nothing is hidden from the investor, the market is open and transparent and all investors have the same level of information at their fingertips
► The risk-free return is freely available to investors
► There are no costs involved in buying or selling, nor will taxes apply. There are also no restrictions on short selling.
When we look at the CAPM, what risk are you taking?
Well in CAPM the risk measure
is systematic risk (market risk) and is defined as BETA.
CAPM ignores non-systematic risk as it is reduced by diversification and therefore there is no “compensation” required.
Systematic risk cannot be diversified away and as such this is the true definition of risk to your portfolio. More accurately it is the
sensitivity of the securities (investments) in relation to the market. i.e. How does the price of an investment move in relation to the movements in the price of the market.
What does a beta of 1 mean?
► A Beta of 1 means that the security will move up and down exactly with the market – a rise in 12% in the market will mean a rise of 12% in the security while a fall of 12% in
the market means a fall of 12% in the security.
What does a Beta below 1 but above 0 demonstrate?
A Beta below 1 but above 0 would mean that the security will move up and down at a slower rate than the market as a whole and been seen as less volatile than the market,
providing its non-systematic risk has been reduced sufficiently through diversification.
For instance, a Beta of 0.5 would mean that the security will move up or down by
5% in response to a 10% movement in the same direction from the market
What does a Beta above 1 demonstrate?
A Beta above 1 would mean that the security moves up and down at a rate above the movement of the market and
as such is seen as being more volatile than the market. For example, a Beta of 1.5 would mean the security will move
up or down by 15% in response to a 10% movement in the market.
