CAPM (capital asset pricing model) Flashcards
What does the structure of expected rates of return describe?
It describes how returns on risky assets are structured when the market is in equilibrium.
What are the assumptions about individual behavior in market equilibrium?
- Investors are rational, mean-variance optimizers.
- They have a single-period investment horizon.
- They have homogeneous/rational expectations.
What are the assumptions about market structure?
- All assets are publicly traded.
- Investors can borrow or lend at a common risk-free rate.
- All information is publicly available.
- No taxes.
- No transaction costs.
What does rational expectations imply?
Investors share the same information and derive the same inputs for the Markowitz portfolio selection model.
What does CAPM state about risk premium?
The risk premium on an asset depends on how much it contributes to the risk of the market portfolio.
Do all these assumptions hold in the real world?
No, many of them do not hold in reality
How is the market portfolio determined?
It results from the aggregation of individual portfolios held by investors.
What conditions must hold when the market is in equilibrium?
- All investments should have the same reward-to-risk ratio.
- All investments should have the same marginal price of risk.
- Excess demand for all investments must be zero.
What does the beta coefficient measure?
The risk of an individual asset relative to the market portfolio (M).
What are the interpretations of beta values?
B < 1: Less risky than the market (defensive asset).
* B = 1: As risky as the market.
* B > 1: More risky than the market (aggressive asset
What does CAPM say about idiosyncratic risk?
There is no reward for idiosyncratic (firm-specific) risk.
What must hold if CAPM is valid?
The expected return-beta relationship must hold for every individual asset and the market portfolio.
What does the Security Market Line (SML) represent?
The relationship between expected return and beta.
What is different in the SML compared to other models?
The horizontal axis represents beta, not standard deviation.
What two factors determine a security’s risk premium on the SML?
- Its relative contribution to market risk (beta).
- The market risk premium (slope of the SML).
What does the SML provide?
A benchmark for evaluating investment performance.
Where do underpriced and overpriced stocks plot on the SML?
- Above the SML: Underpriced (should buy).
- Below the SML: Overpriced (should sell).
What is the key difference between the SML and the CML?
- The CML applies to efficient portfolios.
- The SML applies to both efficient and inefficient portfolios.
Why does the CML ignore the risk factor Ppm?
Because efficient portfolios differ only in the proportion of the market portfolio they contain.
Why is risk adjusted downward in the SML for inefficient portfolios?
Because unsystematic risk is eliminated due to lower correlation with the market.
What is the primary test for CAPM validity?
The expected return-beta relationship must hold empirically.
