CAPM Flashcards
Who Developed CAPM?
Sharpe (1964), Lintner (1965) and Mossin (1966).
What is the CAPM used for?
Describing the relationship between expected returns and risk
Key assumptions of the CAPM?
- Competitive and frictionless market.
2.Investors are mean-variance optimisers - Risk-free lending and borrowing available.
4.Homogenous beliefs
What’s the point in diversifying a portfolio?
When you diversify a portfolio you eliminate the unique risk.
CAPM gives us a way to measure what?
Systematic risk.
Every asset pricing model will give you a way of estimating systematic risk.
- Markets are competitive and frictionless
Investors are price takers
No trading costs
Price taker
Implies that investors cant manipulate prices
Frictionless market
NO taxes
NO portfolio constraints
NO trading costs
Unlimited short selling
- Investors are mean variance optimizers
Investors select a portfolio that gives them the maximum expected return for a given level of risk
- Risk-free asset exists
The investor can either borrow or can lend at the risk-free rate.
Risk- free asset example
Treasury bills
Government bonds
Risk-free asset implication
The investment in that asset will have a minimal risk of default
What is the Capital market line (CML)?
The line representing the risk-return tradeoff of efficient portfolios combining the risk-free asset and the market portfolio.
What is the tangency portfolio in CAPM?
The tangency portfolio m must be the Market Portfolio.
If average risk you would pick this portfolio.
What determines an investors portfolio on the CML?
Their risk tolerance. If higher risk aversion you’re further down the line near the y axis
What portfolio do investors pick?
Every investor will pick a portfolio on the efficient frontier which is known as the CML
- Homogenous beliefs
All investors have identical beliefs about u and V. Expected returns and covariance matrix.
Two conditions in equilibrium
- Every investor holds an optimal portfolio (Every investor has maximized their utility)
- demand=supply
What is the market portfolio?
The overall market of all investable assets, weighted by their market capitalization.
What defines the market portfolio?
It includes all risky assets
Value weighted portfolio
Value weighted portfolio
The amount you invest in an asset is the market value of all assets
First main prediction of the CAPM
The market portfolio (see graph).
all other results for the CAPM follow from the market portfolio
In equilibrium all investors hold cash and the market. what can be derived from this?
The Security market line
What is the security market line (SML)
A line that shows the expected return of an asset as a function of its beta with the market
What does the beta measure?
A measure of systematic risk. A linear relation how sensitive the return of the
asset is to the returns in the market portfolio.
When the market portfolio lies on the efficient frontier other portfolios lie where?
Every portfolio will lie on the security market line (SML)
What kind of risk is rewarded in the CAPM?
Only systematic risk, not idiosyncratic risk.
Second main prediction of the CAPM
The SML (security market line)
What is the market portfolios beta?
1
Beta > 1
Aggressive stock - bigger impact on returns (small firms). If the market goes up invest here.
Beta < 1
Defensive stock - move less than changes in the market index. If the market falls invest here
How is expected return used in practise?
For cost of equity, fund performance, and portfolio construction.
If CAPM was true
Only the market beta explains why expected returns vary across stocks.
Implication of CAPM being true.
You only get higher returns from taking on more systematic risk.
Firm specific risk (idiosyncratic) receives no reward.
According to the CAPM, do stock characteristics impact expected returns once you control for market beta?
No, CAPM implies that only market beta explains expected returns; stock characteristics have no additional impact.
What drives stock returns?
Returns =f(systematic risk) + f(characteristics).
Risk and stock characteristics.
According to CAPM its only risk.
Why is the SML useful?
Practical applications:
1.Cost of equity capital estimations
2.Evaluate fund performance
3.Building optimal portfolios
When estimating the expected return using SML we assume?
Expected market returns and market betas are constant throughout time.
Estimation risk problem?
Using the past to predict the future. We don’t know what the true values are in the future. Predictions may be good but more likely than no they will be very poor.
Issues with the CAPM model
- Can we identify the market portfolio?
- Poor empirical performance
- Do mean-variance efficient frontiers have portfolios with
all positive weights
Issues identifying the market portfolio (Roll Critique) (Roll(1977))
CAPM is not testable since the
market portfolio cannot be observed. Most studies use stock market index as a proxy.
- Poor empirical performance
The standard CAPM using stock market index as a proxy tends to perform poorly in explaining cross-sectional stock returns
Fama and French (1992) beta
Find no relation between average returns and betas in U.S stock returns.
What helps explain average returns beyond market betas
Stock characteristics
Despite CAPM’s poor empirical performance, what support do Harvey and Liu (2020) provide?
They support the inclusion of the market index in linear factor models, noting it appears in every single factor model.
- The market portfolio only included positive weights
It implies the CAPM can be rejected, as the market portfolio (which has all positive weights) would not lie on the efficient frontier.
