CAPM Flashcards
what is capm
It is the sensitivity of the security to the
market that is the appropriate measure of risk.
measures systematic risk of security plus risk free rate
define beta
The sensitivity of a security relative to the market is expressed in terms of its beta.
7 assumptions for capm
- Investors are rational and risk averse, making decisions on the basis of risk and
return alone. - All investors have an identical holding period.
- The market comprises many buyers and many sellers, and no one individual can affect
the market price. - There are no taxes, no transaction costs and no restrictions on short-selling.
- Information is free and is simultaneously available to all investors.
- All investors can borrow and lend unlimited amounts of money at the risk-free rate.
- The quantity of risky securities in the market is fixed, and all are fully marketable (which
means the liquidity of an asset can be ignored).
3 limitations of capm -
What to use as the risk-free rate? - truly risk free
What is the market portfolio? - depending on which index is
used, the betas are significantly different.
The suitability of beta - the beta of a security must be stable or predictable. Betas are calculated from past experience and do not seem to be stable over time
Summarise APT compared to CAPM 5
Still argues argues that returns are based on the systematic risk to which a security is
exposed,
APT is based on the belief that asset prices are determined by more than just one type of market risk.
each investor holds a unique portfolio with its own particular degree of exposure to the fundamental economic risks that influence asset returns, as opposed to an identical market portfolio.
the model does not tell us which factors are
relevant. In addition, the number and nature of those factors is likely to change over time and
between economies.
more betas have to be calculated,
and there is no guarantee that all the relevant factors have been identified
4 influences of security returns
- unanticipated inflation;
- changes in the expected level of industrial production;
- changes in the default risk premium on bonds; and
- unanticipated changes in the return of long-term government bonds over Treasury bills
(shifts in the yield curve).
summarise EMH
in an open and efficient market, security prices fully reflect all available information and rapidly adjust to any new information
market prices are always the correct price for any given security and reflect the best estimate of their
true intrinsic value
impossible to achieve returns in excess of average
market returns consistently through stock selection.
Weak-form efficiency
This states that current security prices fully reflect all past price and trading volume information, and future prices cannot be predicted by analysing technical
Semi-strong efficiency
Semi-strong efficiency implies that neither fundamental analysis, which looks at the historical
financial performance of a company, nor technical analysis, which charts historical trading
data, will reliably be able to help identify whether a security is over- or undervalued.
strong form efficiency
all information includes not only public information, but also private information,
typically held by corporate insiders, such as officers or executives of a company or their
advisers.
prospect theory/loss aversion (4)
people do not always behave
rationally, particularly with respect to their risk tolerance
Individuals are much more distressed by prospective losses
than they are made happy by equivalent gains
and respond differently to equivalent
situations depending on whether that situation is presented in the context of a loss or a gain
but if faced
with the possibility of losing money, they often make riskier decisions aimed at loss aversion.
This may include a reluctance to realise losses,
