Chapter 11 Flashcards
What does a beta of 1.0 mean?
The asset has average market risk.
What is the key assumption of CAPM about investor behavior?
Investors are rational and seek to maximize return for a given level of risk.
What is systematic risk?
Market risk that affects a large number of assets and cannot be diversified away.
How do companies use CAPM in real life?
To estimate the cost of equity and make investment/project decisions.
What is the slope of the SML equal to?
The market risk premium E(Rm) - Rf
What is market risk also known as?
Systematic risk or non-diversifiable risk.
What does it mean if a security plots above the SML?
It is undervalued (offering a higher return for its risk).
In CAPM, what does Rf represent?
The risk-free rate.
What is portfolio variance?
A measure of how the returns of all the assets in the portfolio interact.
What is the expected return on a zero-beta asset under CAPM?
The risk-free rate.
What is firm-specific risk also known as?
Unsystematic risk, diversifiable risk, or unique risk.
What happens to total risk as more assets are added to a portfolio?
Unsystematic risk decreases, while systematic risk remains.
What does the slope of the security market line (SML) represent?
The market risk premium.
What is total risk made up of?
Total risk = systematic risk + unsystematic risk.
What is the market risk premium in CAPM?
E(Rm) – Rf, the extra return over the risk-free rate.
What is alpha (α) in a regression model?
The asset’s return independent of market movement; positive alpha may indicate undervaluation.
what does this represent in the regression equation?
The error term – the unsystematic risk component of the asset’s return.
How is a portfolio’s expected return calculated?
As the weighted average of the expected returns of the assets in the portfolio.
What does a beta greater than 1.0 indicate?
The asset is more risky than the market.
What does CAPM assume about markets?
That they are efficient and all investors have access to the same information.
What is the CAPM formula for expected return?
E(Ri) = Rf + βi(E(Rm) – Rf)
Why does holding only one asset or assets in the same industry increase risk?
Because it concentrates unsystematic risk, which could be diversified away.
What does the regression equation represent?
The relationship between an asset’s return and the market’s return, used to estimate beta.
What is beta (β) in finance?
A measure of an asset’s systematic risk relative to the market.
Why can CAPM ignore unsystematic risk?
Because it assumes investors hold well-diversified portfolios.
What is a portfolio?
A collection of assets held by an investor.
What is the role of regression in estimating beta?
It shows how a security’s returns move with the market’s returns.
What is unsystematic risk?
Firm-specific risk that can be eliminated through diversification.
What happens to unsystematic risk in a well-diversified portfolio?
It becomes negligible.
What does “expected return” mean in finance?
The average return if an investment process is repeated many times.
What is the purpose of CAPM?
To quantify the relationship between systematic risk and expected return.
What does it mean if a security plots below the SML?
It is overvalued (offering a lower return for its risk).
What is the Systematic Risk Principle?
There is a reward for bearing systematic risk, but not for bearing unsystematic risk.
What does a beta less than 1.0 indicate?
The asset is less risky than the market.
How are expected returns calculated?
By taking the weighted average of possible returns, using probabilities as weights.
What is diversification?
The practice of spreading investments to reduce risk without sacrificing expected return.
What is the Security Market Line (SML)?
A graphical representation of CAPM showing expected return as a function of beta.
What is the main critique of CAPM?
It relies on assumptions (like market efficiency and a single-period investment horizon) that may not hold in reality.
What do variance and standard deviation measure in investing?
The volatility or risk of returns.
Why is beta considered a better measure of risk than standard deviation in CAPM?
Because beta isolates the systematic portion of total risk, which affects expected return.
