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FE 2020 > CAPM > Flashcards

CAPM Flashcards

1
Q

When r(a) is the appropriate measure?

A

When decisions are being taken on a forward-looking basis:
• Represents the mean of all the returns that may possibly occur over the investment holding period
• Best estimator of expected (short-term) future return • • • • The best gauge of the expected risk premium

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2
Q

When geometric mean r(g) is the appropriate measure?

A

Best measure of realized (past) returns on an investment

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3
Q

Measure of risk?

A

Volatility is not a complete measure of risk– higher moments of returns

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4
Q

What is Skewness?

A

A measure of symmetry, or more precisely, the lack of symmetry
• A distribution, or data set, is symmetric if it looks the same to the left and right of the center point
Negative values for the skewness indicate data that are skewed left - Reflects tail risk or crash risk
• Positive values for the skewness indicate data that are skewed right

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5
Q

What is Kurtosis?

A

A measure of whether the data are peaked or flat relative to a normal distribution

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6
Q

What is Leptokurtic Distribution?

A

-> (K > 3)
A distribution with wide tails and a tall narrow peak is called leptokurtic Compared with a normal distribution, a larger fraction of the returns are at the
extremes rather than slightly above or below the mean of the distribution

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7
Q

What is Platykurtic Distribution?

A

-> K < 3
A distribution with thin tails and a relatively flat middle is called platykurtic Relative to a normal distribution, a larger fraction of the returns are clustered around the mean

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8
Q

How do you know if there are any diversification benefits?

A

As long as asset returns are not perfectly correlated, the standard deviation (risk) of the portfolio is less than the weighted average of the assets standard deviations

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9
Q

Main goal of diversification?

A

Diversification reduces variability of returns if returns are not perfectly correlated

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10
Q

What is Diversification?

A

Strategy designed to reduce risk by spreading the portfolio across many investments.

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11
Q

What is Unique Risk?

A

Risk factors affecting only that firm - Also called “diversifiable risk”

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12
Q

What is Market Risk?

A

Economy-wide sources of risk that affect the
overall stock market
- Also called “systematic risk”
- Reason why stocks have a tendency to move together – common factor affecting all stocks

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13
Q

What are Two Implications From Diversification?

A
  1. Only systematic risk determines expected returns
    - Since the unique risk can be diversified away for free by forming portfolios, investors can rationally only demand compensation for the systematic (non-diversifiable) risk
    - Marginal systematic risk of an asset gauged by its β-value relative a well-diversified portfolio (not by the total risk)
  2. Value Additivity
    - Investors that can diversify on their own account will not pay extra for firms that diversify
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14
Q

Markowitz Portfolio Theory

A

Possible to build a portfolio theory from our previous insights
1. Form diversified portfolios that reduce the risk (standard deviation) since asset returns are not perfectly correlated
• Reduce standard deviation, below the level obtained from a simple weighted - average calculation
• Correlation coefficients make this possible
2. Derive the exact principles of how to construct well-diversified portfolios
3. Define and find the various weighted combinations of stocks that create the set of efficient portfolios

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15
Q

What is an efficient portfolio frontier?

A

All portfolios that are not mean-variance dominated by another portfolio:

  • Not possible to rank portfolios in this set by the mean- variance criterion
  • Part of the portfolio frontier that starts from the minimum variance portfolio and move upwards as portfolio risk increases
  • NOTE: We only consider risky assets
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16
Q

Explain short selling

A
  • Borrow a stock, sell it to cash in and then restore it to the original owner by buying it back later
  • Possible to go short in order to gain on expectations that stock price will decline
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17
Q

How stock prices are assumed to look?

A

Stock prices assumed to follow a lognormal distribution -> But since negative stock prices are impossible, it is incorrect to assume that they follow a normal distribution:
-> Characterized only by two moments
μ (expected value — mean) and σ (standard deviation)

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18
Q

What is risk aversion?

A

The term risk-averse refers to investors who, when faced with two investments with a similar expected return, prefer the lower-risk option. Risk-averse can be contrasted with risk seeking.

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19
Q

What happens when the correlation between two assets is -1?

A

Investor has the opportunity to create a perfectly hedged position. -> variance of the portfolio is 0

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20
Q

Step to be taken in Mean-Variance Analysis?

A
  1. Specification of a set of securities for consideration.
  2. Analysis of the prospects of these securities. Expected returns, variances and covariances must be estimated for all the securities being considered.
  3. The efficient set is determined. With the addition of risk-free asset, the efficient set becomes a straight line.
  4. The fourth and final stage is to identify the investors optimal portfolio (personal preferences).
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21
Q

What CAMP says?

A

The market portfolio is an efficient portfolio and hence the tangency portfolio

22
Q

What is the The Security Market Line?

A

A line that serves as a graphical representation of CAPM, which shows different levels of systematic (market) risk of various marketable securities against the expected return of the entire market at a given point in time.
The SML is a visual of the capital asset pricing model (CAPM), where the x-axis of the chart represents risk in terms of beta, and the y-axis of the chart represents expected return. The market risk premium of a given security is determined by where it is plotted on the chart in relation to the SML.

23
Q

Name CAPM Interpretation

A

The assets expected return is the sum of risk free and assets risk premium proportional to the market risk premium.

24
Q

Explain negative beta values

A

Something that generates return that is lower than the risk premium (insurance policy -> negative return in general)
Individual stocks cannot have negative returns (with an exception for a really short period of time)

25
Q

Robustness of CAPM

A

Modifying some of its assumptions leaves the general model unchanged. BUT: When several assumptions are modified simultaneously, the departure from the standard CAPM may be larger

26
Q

Normative Assumptions Behind CAPM

A
  1. Investorsevaluateportfoliosbylookingatthe expected returns and standard deviations of the portfolios over one -period horizon
  2. Investors are never satiated
  3. Investors are risk - averse
  4. Assets are infinitely divisible
  5. Perfect competition
  6. There is a risk free rate of interest at which an investor may either lend or borrow
  7. Investments are limited to a universe of publicly traded financial assets
  8. All investors have the same one - period horizon
  9. The risk free rate is the same for all investors
  10. Information is freely and instantaneously available to
    all investors
  11. Investors have homogeneous beliefs
27
Q

Describe the relationship between M/B (Market to book) and returns

A

Strong negative relation between market-to-book equity and return regardless of what other explanatory variables were included in the regression
-> the higher the B/M the greater the company value (markets have incorporated some intangible assets into the value)

28
Q

Explain beta strategy

A

invest in market portfolio or well diversified portfolio on the SML line -> passive investment

29
Q

Explain smart beta strategy

A

Invest in specific measure (ex. B/M) -> something between passive and active investment

30
Q

What is Arbitrage Pricing Theory?

A

Multi-factor asset pricing model based on the idea that an asset’s returns can be predicted using the linear relationship between the asset’s expected return and a number of macroeconomic variables that capture systematic risk.

Implementation

  1. Identify the macroeconomic factors
  2. Estimate the risk premium for each factor 3. Estimate the factor sensitivities
31
Q

Three APT Implications

A
  1. An asset with zero exposure to all factors has a zero risk
    premium -> (A portfolio constructed to have zero sensitivity to all macro factors is de facto risk-free and should be priced to offer the risk-free rate of return)
  2. A diversified portfolio constructed to have exposure to only one factor will have a risk premium that varies in direct proportion to the portfolio’s sensitivity to that factor
  3. If the risk premium on each of the APT factors is proportional to the market risk premium (CAPM) then the APT and CAPM are identical
32
Q

Three components of the APT

A

 Factors move up and down with the economy, and affect the future cash flows of securities.
 Factor loadings for each security, for each factor, tell you how much the security moves (on average, in percent) when the factor moves by 1%.
 Factor risk-premiums for each factor, tell you how much higher a discount-rate investors apply to a security if its factor loading on a particular factor is higher by one

33
Q

What is The three factor model?

A

Two basic principles are common

  1. Investors require extra expected return for taking on risk
  2. Investors primarily concerned with the risk they cannot diversify away
34
Q

On what the position of a portfolio in a ranking based on rate of return depends on?

A
  • Risk level of the portfolio
  • Performance of the market
  • Skill level of the portfolio manager
35
Q

Name three kinds of risk

A
  1. portfolio total risk
  2. portfolio market (systematic) risk
  3. non-systematic risk
36
Q

Describe the Sharpe ratio

A

Is used to help investors understand the return of an investment compared to its risk. The ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk.
Appropriate if portfolio manager limited in his/her choice of assets e.g. due to restrictions on fund, i.e. limited in ability to diversify

37
Q

Describe the Modigliani & Modigliani Measure (aka Modigliani risk-adjusted performance)

A

Similar to Sharpe ratio -> helps in measuring the returns of portfolios after adjusting the risk associated i.e. it measures the risk-adjusted return of the different investment portfolio relative to a benchmark.

  • > negative: underperform
  • > positive: overperform
38
Q

Describe the Treynor Index

A

The Treynor Index measures the risk-adjusted performance of an investment portfolio by analyzing a portfolio’s excess return per unit of risk. The measure of market risk used is beta, which is a measure of overall market risk or systematic risk. The higher the Treynor Index, the greater “excess return” being generated by the portfolio per each unit of overall market risk.

39
Q

Describe the Jensen’s measure

A

Jensen’s alpha, is a risk-adjusted performance measure that represents the average return on a portfolio or investment, above or below that predicted by the capital asset pricing model (CAPM), given the portfolio’s or investment’s beta and the average market return

40
Q

Describe the Appraisal ratio (AR) (aka Information Ratio)

A

Used to measure the quality of a fund manager’s investment-picking ability. It compares the fund’s alpha to the portfolio’s unsystematic risk or residual standard deviation.

41
Q

Describe the Treynor’s Measure and T2

A

A performance metric for determining how much excess return was generated for each unit of risk taken on by a portfolio.

42
Q

Two dimensions of Active Management

A
  • Market timing
    • Macro forecasting
  • Security analysis
    • Micro forecasting
43
Q

Describe the Treynor-Black Model

A

Pure CAPM does not hold! There is an alpha. -> two strategies combined: r =(1−w)r(m) +wr(a)

44
Q

What is Company Cost of Capital?

A

Defined as the expected return on a portfolio of all the company’s existing assets
- It is the opportunity cost of capital for investment in the firm’s assets

45
Q

Name two Adjustments to Company Cost of Capital

A
  1. Risk of investment projects may differ from the risk
    of the firms assets that determine the company cost
    of capital
    • Project beta values
  2. Adjustment for financial leverage
    • Risk of equity higher in a leveraged firm
46
Q

What is R^2?

A

The R^2 of the regression provides an estimate of the proportion of firm risk that can be attributed to market risk
-> The balance (1-R^2) can be attributed to firm specific risk.

47
Q

What affects betas?

A
  1. Determinant 1: Product type
    - > The beta value for a firm depends upon the sensitivity of the demand for its products and services to macroeconomic factors that affect the overall market
  2. Determinant 2: Operating leverage effect (FC vs VC)
  3. Determinant 3: Financial leverage
48
Q

What do Modigliani & Miller say about cost of capital?

A

Value of assests does not change with capital structure -> WACC remains constant

49
Q

Difference between alfa and beta?

A

Beta is a historical measure of volatility. Beta measures how an asset (i.e. a stock, an ETF, or portfolio) moves versus a benchmark (i.e. an index (market)). Alpha is a historical measure of an asset’s return on investment compared to the risk adjusted expected return.

50
Q

What is capital market line?

A

The capital market line (CML) represents portfolios that optimally combine risk and return. Capital asset pricing model (CAPM), depicts the trade-off between risk and return for efficient portfolios. It is a theoretical concept that represents all the portfolios that optimally combine the risk-free rate of return and the market portfolio of risky assets. Under CAPM, all investors will choose a position on the capital market line, in equilibrium, by borrowing or lending at the risk-free rate, since this maximises return for a given level of risk.

  1. The capital market line (CML) represents portfolios that optimally combine risk and return.
  2. CML is a special case of the CAL where the risk portfolio is the market portfolio. Thus, the slope of the CML is the Sharpe ratio of the market portfolio.
  3. The intercept point of CML and efficient frontier would result in the most efficient portfolio called the tangency portfolio.
  4. As a generalization, buy assets if sharpe ratio is above CML and sell if sharpe ratio is below CML.
51
Q

What is security market line?

A

The security market line is the theoretical line on which all capital investments lie. Investors want higher expected returns for more risk.

FE 2020 (15 decks)

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