Ch. 8 CAPM

Question 1

What does CAPM do?

Answer 1

Explains the relationship between risk and return on a financial security

Question 2

Why is CAPM needed?

Answer 2

Traditional evaluations of portfolio risk require calculating covariances between all possible pairs of assets in the portfolio; this takes a long time and can be very complicated!

Question 3

If have N assets, how many covariances are there to calculate?

Answer 3

(N^2-N)/2

Question 4

What does Sharpe’s (1963) market model suggest?

Answer 4

That shares tend to move in varying degrees in line with the market itself (ie. market price increases, so do most prices of assets in the market)

Question 5

Sharpes market model: what does it mean if β is equal to, less than or greater than 1?

Answer 5

Equals 1: share rises/falls by same % as the market
Less than 1: share fluctuates less % than the market
Greater than 1: share fluctuates more % than the market

Question 6

Model assumptions?

Answer 6

See slide 11

Question 7

What is the Capital Market Line?

Answer 7

A straight line passing through the risk-free RofR and the expected RofR on the market portfolio

Question 8

How is the standard deviation of the return on a risk free asset denoted? And the same for the whole portfolio?

Answer 8

R: σ(R)=0
σ(p)=wσ(m)

where w=weight invested in the risky portfolio

Question 9

What does the securities market line measure?

Answer 9

It measures the relationship between β (systematic risk) and the firm’s expected RofR

Question 10

What is ρ(im)? What is its significance?

Answer 10

If ρ(im) then if the market does well so does asset i BUT this also means it does not provide diversification to investors tf the asset must have a larger expected return to make investors want to hold it

Question 11

Securities market line equation IN WORDS?

Answer 11

Expected return on asset ‘i’ = risk-free rate + (β(i) multiplied by the expected excess return on the market portfolio)

(if β(i)=1 then expected return on i=expected return on the market)

Question 12

What is a defensive security?

Answer 12

A security that has a lower expected return than the market (β less than 1) (eg. energy, food etc.)

Question 13

What is an aggressive security?

Answer 13

A security that has a higher expected return than the market (β> 1) (eg. technology, luxuries etc.)

Question 14

Note:

Answer 14

Is worth considering whether someone should consider the risk of their house investment or their human capital when choosing a market portfolio

Question 15

Draw the securities market line diagram?

Answer 15

See notes (now!)

Question 16

What does the CAPM suggest the required RofR depends on?

Answer 16

3 components:

1) ‘Price’ of time (R)
2) Quantity of risk (measured by β(i))
3) Market price of risk (measured by E(R)-R*) (don’t worry too much about this)

Question 17

How would one measure the beta coefficient?

Answer 17

It has been empirically estimated using historical time-series data

Question 18

What will affect the estimated beta coefficient?

Answer 18

time period over which return is calculated
frequency of the data (daily, weekly, monthly or quarterly)
the market index used (eg. FTSE 100)

Question 19

What else may an investor want to consider?

Answer 19

The stability of β(i) over time

Question 20

Note:

Answer 20

it is important that the time period and frequency used for estimation of the beta is the same for both the portfolio and the market.

Question 21

See

Answer 21

Example slide 33-36!

Question 22

Equation when estimating beta using regression equation?

Answer 22

Same as SML but with +e(i) on the end to measure the regression error (specific risk) (measured by st. dev. of the error)

Question 23

What is the risk that cannot be diversified away?

Answer 23

Systematic risk

Question 24

What are the 5 key predictions of CAPM?

Answer 24

1) Intercept term in equation should be equal to zero, that is α= 0; if it were non-zero it would mean that CAPM model is missing something as a complete explanation of a portfolio’s excess return.
2) Beta coefficient should be sole explanation of rate of return on the risky portfolio. The estimated slope b should be positive and not differ significantly from the risk premium on the market portfolio, RPm = Rm – R.
3) Should be linear relationship given by beta between average portfolio risk premium and average market risk premium.
4) Over time, Rm should exceed R, since a market portfolio is riskier than the risk-free asset.
5) Other explanatory variables such as dividend yield, firm size and price–earnings ratios should not prove to be statistically significant in predicting the required rate of return.

Question 25

Draw diagram showing theoretical vs. empirical SMLs?

Answer 25

see notes

Question 26

How does the theoretical and empirical SMLs differ?

Answer 26

Securities with low betas tend to earn higher RofR than the theoretical model would suggest and vice versa

Question 27

What does evidence show?

Answer 27

That factors other than beta (Q of risk) can explain a portfolios excess return (see slide 43)

Question 28

What did Fama and French (1992) look at?

Answer 28

US share returns over 1963-1990, found no reliable connection between beta and average return

Question 29

What is the idea behind the Sharpe ratio?

Answer 29

The excess return in the numerator needs to be compared to the risk of the portfolio in the denominator

Question 30

What is the Sharpe ratio used for?

Answer 30

Used to examine the performance of an investment by adjusting for its risk

Question 31

2 pros of the Sharpe ratio?

Answer 31

Easy to compute from observed returns

Easy to compare it between different categories of investment classes (eg. stocks, bonds etc.)

Question 32

2 cons of the Sharpe ratio?

Answer 32

Ratio can be sensitive to the start and end dates used

Ratio can give misleading signals about the risk of a portfolio

Question 33

4 issues of the CAPM model?

Answer 33

1) Indexes not necessarily the true market portfolio (eg. FTSE All-share still misses other assets such as precious metals etc._
2) One-period model: in reality investments are made over many periods!
3) ‘Risk free rate’ - what is it actually? In reality, government bonds are not ‘risk-free’ (eg. greek gov bond defaults)
4) Unrealistic assumptions

Question 34

4 unrealistic assumptions the CAPM model makes?

Answer 34

rationality
full info. on risk levels
all assets available to be bought
investors can borrow at risk free rate

Question 35

see

Answer 35

last 3 slides: summary on key concepts if needed