Ch. 8-9: Portfolio Theory CAMP Flashcards
Define covariance
Covariance is a measure of the way in which two random variables move in relation to each other- If positive, the variables move in the same direction, vice-versa
The theorem that states that an investor will always achieve the highest expected return at a given risk level, regardless of risk aversion and preference by holding the best efficient portfolio and through borrowing and lending.
What is this theorem called?
Tobin’s Separation Theorem (Two-Fund Separation)
Following CAPM, in equilibrium, every asset must be priced so that its risk-adjusted required rate of return lies exactly on _____
Security market line (SML)
The security market line (SML) has _____ on the y-axis, and ____ on the x-axis
SML: plots expected return (y) against the beta (x)
The capital market line (CML) has _____ on the y-axis, and ____ on the x-axis
CML: plots expected return (y) against the standard deviation (x)
The capital asset pricing model states that
the expected risk premium on each investment is proportional to its beta
True/False
True
The company cost of capital can only be used to discount project cash flows if the project is____
a carbon copy project: i.e., with similar risk to that of the firm as a whole
Project cost of capital does not depend on the identity of the company that considers accepting it. True cost of capital depends on what the capital is used for (i.e. project risk).
True/ False
True
According to CAPM, every project/asset that lies above the SML shall be ______, and every project that lies below the SML shall be _____
Accepted/ rejected
According to CAPM, every project/asset that lies above the SML shall be ACCEPTED , and every project that lies below the SML shall be REJECTED
On the CML graph, where is the risk-free asset plotted?
The intercept of CMLwith the y-axis due to the assumption of risk-free asset being risk-free (no standard deviation)
A capital budgeting project concerning oil drilling is presented to three firms: Texaco, GE, and Heinz.
Do you expect Texaco, GE and Heinz to use different or identical cost of capital when analysing whether to accept the capital budgeting project?
Identical: the different companies are evaluating the same project, wherefore the right cost of capital to be used is the project cost of capital - not the company cost of capital
Therefore, IDENTICAL cost of capital
Under uncertainty, there are two ways to value risky cash flows (i.e. two ways of adjusted for risk when calculating NPV):
As long as one is consistent with the choice of method, their results should be equivalent. Which are these methods?
- Risk-adjusted discount rate method
- Certainty-equivalent method
What is the risk-adjusted discount rate method for project evaluation?
The adj. discount rate method calculates NPV by discounting expected cash flows at a cost of capital equal to the return and investor could get from investing in a financial asset with the same risk as the project
The certainty equivalents method:
A) transforms the expected cash flows to certainty equivalent cash flows
B) corrects for risk in cash flows and for the time-value in cost of capital
C) NPV is calculated using CEQ as numerator and risk-free asset in the denominator
D) all of the above
D) all of the above
