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CAPM essay Flashcards

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1
Q

what does the CAPM seek to find

A

How the expected returns are related to the systematic risk - also known as beta

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2
Q

CAPM is a one-factor model, what does this mean?

A

It means that there is only one factor of systematic risk, the market risk, and that this is the only detriment of asset returns

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3
Q

Who developed CAPM

A

William Sharpe (1964) first introduced the CAPM and the SML, then John Linter (1965) introduced the CML and said that it was needed to use in union with the SML for investors, Jan Mossin (1966) spoke further on the CAPM and SML. All 3 are regarded as the people who developed this financial model

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4
Q

What is the CAPM equation

A

Sharpe, Linter and Mossin developed this equation

E(Ri) = Rf + Betai[E(Rm)-Rf]

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5
Q

E(Ri) = Rf + Betai[E(Rm)-Rf] - explain this in words

A

E(Ri) - Expected returns of asset i
Rf - Risk free rate
Betai - the beta of asset I
[E(Rm)-Rf] - The risk premium

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6
Q

E(Rm)-Rf. What is the risk premium ?

A

the additional return that investors require for taking on systematic risk beyond the risk-free rate

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7
Q

Who introduced SML and CML relationship

A

John Linter (1965) was the first to introduce the concept of the SML and CML relationship

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8
Q

What does the SML show

A

The security market line shows the expected return of an asset for any given level of systematic risk. Linter did not say specifically that the SML was the graphical representation of the CAPM but you can interpret it as that as it follows the same equation as CAPM

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9
Q

What does the CML show

A

The capital market line is the efficient frontier of portfolios that can be constructed by using a combination of risk-free assets and risky portfolios of assets, the efficient frontier shows the optimal set of portfolios for investors to choose from.

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10
Q

What is the relation between the 2

A

John Linter said in his 1965 paper that the SML and CML are “two sides of the same coin” as he believes that the two complement each other perfectly and should always be used in conjunction with one another in order to make the most informed investment decisions

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11
Q

What is the SML equation

A

E(Ri) = Rf + Betai[E(Rm)-Rf]

THE EXACT SAME AS THE CAPM EQUATION

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12
Q

What is the CML Equation

A

E(Rp) = Rf + [E(Rm) - Rf] / σm * σp

E(Rp) = expected return on portfolio p
Rf = risk-free rate of return
E(Rm) = expected return on the market portfolio of all risky assets
σm = standard deviation of returns on the market portfolio
σp = standard deviation of returns on portfolio p

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13
Q

who first developed the CML equation?

A

Harry Markowitz in his 1952 paper “Portfolio Selection” first brought to light the CML equation, which was later adopted by Sharpe, Linter and Mossin to create the relation between the SML and CML

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14
Q

What are the main testable predictions of the CAPM

A
  1. That beta (systematic risk) is the only thing that affects returns
  2. That the risk-free rate remains consistent no matter changes in economic factors
    3.
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15
Q

How do you tests to see if expected returns are entirely related to the beta?

A

This can be tested by looking at the relationship between the historical returns of an asset and its beta and then comparing it to the predicted relationship of the CAPM.

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16
Q

What does CAPM say about beta

A

The model states that the slope coefficient of a regression of asset returns against their betas, that the slope should be positive and statistically significant.

17
Q

What does it mean if the Beta is statistically large

A

If the beta is statistically large it means that the asset’s return is not solely based on the beta and that other factors come into play. This questions the model’s validity and provides evidence that there is more than one systematic risk factor

18
Q

What do Sharpe and Linter say about the consistent risk-free rate

A

One of the CAPM assumptions is that the risk-free rate, remains consistent and the same no matter changes in inflation or any other economic circumstance

19
Q

How do you test this?

A

In practice, this is rather hard to test as there are multiple ways to do it. One way is to use the U.S. treasury bills as a proxy for the risk-free rate as it is believed for them they have very little default risk as they are fully backed by the government

20
Q

What do the results show

A

If the results are consistently different from the expected returns it shows that the risk-free rate does not remain constant, this again further questions the models validity as a reliable liner factor model

21
Q

What are some of the practical uses of CAPM

A

1.

22
Q

What are some alternatives to the CAPM

A
  1. Arbitrage Pricing Theory
  2. Fama and French three-factor model
  3. Intertemporal CAPM
23
Q

Why is there alternatives to the CAPM

A

Alternatives are needed as CAPM is only a single-factor model and deals with only one factor of systematic risk, the other models include multi-factors of systematic risk which in theory can make them more reliable than CAPM

24
Q

What is Arbitrage Pricing Theory?

A

Developed in the 70’s by Stephen Ross as an alternative to the CAPM, the main premise of this model is that the linear relationship between the assets return and a number of underlying factors, compared to CAPM;s just one factor

25
Q

What are some of the underlying factors APT deals with?

A

Some of the main ones are:
1. Macroeconomic factors
2. Industry Specific factors
3. Company specific factors

26
Q

What are the Macroeconomic factors?

A

This looks at factors such as economic inflation, GDP growth and interest rates, which may affect the overall economy and the performance of companies operating in that economy.

27
Q

What are industry-specific factors?

A

These include factors such as technological advancements, regulatory changes, and competitive dynamics, which may affect the performance of companies operating in specific industries.

28
Q

What are company-specific factors?

A

These include factors such as management quality, financial leverage, and earnings growth, which may affect the performance of individual companies.

29
Q

How do these relate to returns

A

The APT assumes that the expected return of a security is a linear function of its sensitivity to each of these systematic risk factors. The APT provides a framework for estimating the expected return of a security based on its exposure to these risk factors, and it can be used to evaluate the relative attractiveness of different investment opportunities.

30
Q

Main differences between CAPM and APT

A
  1. Obviously, the largest difference is the number of systematic risk factors included in each model

2.

31
Q

What are the main bases of APT?

A

That the returns on an asset are due to a number of underlying risk factors, According to the model, if these risk factors cause an asset’s price to differ from its expected value, there is a chance for arbitrage, which would bring the asset’s price back to its equilibrium level.

32
Q

How do you test the validity of the APT?

A

One of the best ways is to test is by doing cross-sectional regressions

33
Q

What are some steps to cross-sectional regressions

A
  1. Identify risk factors that could influence the return of your asset
  2. Estimate the factor sensitivity to each asset, by doing multiple regressions model to estimate risk sensitivity and risk premiums
  3. Look at the fit of the model, by this I mean look at the statistical results of the model and determine if they are a good fit
  4. Test for significance, by doing a T-test to see if the coefficients are statistically significant to the significance given
  5. Finally, compare predicted returns with actual returns to determine whether the model does a good job of predicting how systematic risk impacts returns
34
Q

How would you determine if the model is good at predicting

A

If the actual returns are highly correlated with the predicted returns, it suggests that the APT is a good model for explaining the relationship between risk factors and asset prices.

35
Q

What is Fama and Frenches model

A

This model seeks to explain the returns on an asset or a portfolio, using multiple factors rather than just the market as a whole

36
Q

What are the 3 Fama and French factors used to explain the differences in returns between portfolios or assets

A
  1. Market risk, the return of the overall market
  2. Size, this factor relates to the theory that small-cap companies tend to have higher returns than large-cap ones over a long period of time
  3. Value - value stocks tend to have larger returns than growth stocks in the long run
37
Q

What is market risk in Fama and French?

A

Market risk is the systematic risk of the market and is represented by the excess returns of the market over the risk-free rate. The market risk factor is captured by the beta coefficient in the CAPM model, which measures the sensitivity of an asset’s returns to changes in the overall market.

38
Q

What is the size factor in Fama and French?

A

The size factor in the Three-Factor Model captures this risk by looking at the difference in returns between small-cap stocks and large-cap stocks. Small-cap out preforms large-cap over a long period of time

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