Chapter 13 - V2 Flashcards
According to the capita lasset pricing model, the market portfolio is …?
efficient. This means that it cannot be improved in terms of expected returns without also taking on more risk.
Consider a case where stock X and Y are affected by news so that their expected return increase by say 2% each, while stock Z and W decrease by 2%, and the expected market return remains constant.
Assume market prices remain unchanged. What effect will this have on the market?
THe market portoflio is no longer efficient. To understand why, consider what we could do. If we hold the market, we could sell the stocks that had decreased expected returns, and buy the ones with increased exected returns - all with no additional risk.
to improve the performance of their portfolios, investors who hold the market portfolio will compare the expecgted return of their individual securitries by the required return from the capital asset pricing model:
rs = rf + beta(E(Rmkt) - rf)
Expected rerturn from market remained unchanged. risk free return remain unchanged. beta remain unchanged. Thus, the required return rs will represent a possibility if it is lower than the expected return.
Recall the security market line, and the axes
SML relates a beta value to required return to take on this level of risk (common risk). Therefore, beta is along the x-axis, while required return is on the y-axis.
The difference between a stocks expected return and required return according to the security market line is known as …?
The alpha of the stock
What is the alpha of a stock
alpha of a stock is the difference between its expected return and the required return that is provided by the capital asset pricing model.
alpha = E(Ri) - Ri
alpha = E(Ri) - rf - beta(E(R_mkt) - rf)
What can we say about the SML when the market portfolio is efficient
All stocks will lie on this straight line.
Elaborate on the general process of re-adjustment in regards to SML
IF someting happens, like a big event/news, the stock may suddenly have higher expected return than required return. This gives a positive alpha, and therefore an opportunity. However, as people make use of the opportunity, the stock will quickly find its place on the security market line after adjustment. This is because as the demand for the stock increase, the price will go up. And when the price moves up, the expected return declines. This will eventually create a balance where the expected return equals the required return. The variable that equates them, is the price.
The same procedure happens the other way, with negative news.
The adjustment-reaction process of stocks to force them back on the security market line creates two important conclusions in regards to the capital asset pricing model, name and elaborate on them
1) While hte CAPM conclusion of efficient market is always efficent may not be literally true, the competition among investors will make it approximaltey true. Investors chase for positive alpha stocks (or non zero alpha stocks) is a driving force for keeping the market efficient most of the time.
2) There may actually exist traidng opportunities in regards to nn-zero alpha stocks that one can utilize to beat the market.
If investors attempt to buy a stock with a positive alpha, what is likely to happen to its price and expected return? How will this affect the alpha?
Buying a stock with a positive alpha will lead to increased demand for that stock. With increased demand, we will see increased stock price. When the stock price increase, the expected return decrease, as the other factors (like dividend, growth etc) remains unchanged or fixed. This will reduce the alpha until it reach the point of balance.
What is the consequence of ivnestors exploiting non-zero alpha stocks for the efficiency of the market portfolio?
Exploiting non zero alpha stocks will in a compatitive environment will drive alpha to zero, which cause a balance. Although the alphas are not zero all the time, they will generally be close to zero, and if not, they will very quickly be reacted upon and go to zero because of competition.
From al lthis, we know that the market portfolio is not necessarily efficient all the time, but it is efficient most of the time and approximate an efficient state.
Elaborate on the no-trade theorem
The no-trade theorem says that prices will adjust, and thereby also the epxected return and alphas, without trade ever happening.
It is based on the reasoning: if a news comes out that generates a positive alpha, in order for someone to benefit on it, someone must be willing to sell the stock at the old price. However, since the owners of the stock has the same information as the ones who want to buy it, they will not accept this price. They will instead seek the price that creates a balance. And since this creates a balance, there is no point in making the trade anymore.
This no-trade theorem depends on fierce and active competition.
In order to profit on a positive alpha stock, someone must …
be willing to sell it
What is the ultimate conclusion of investing strategy accoridng to the capital asset pricing model?
How does this conclusion impact the deicisions of “naive” investors wiht little informaiton, little time spent researching, and in general just not good investors?
Holding the market portfolio, and adjusting it to your preferred level of risk by utilizing the risk-free rate. Either to borrow or to hold.
The strategy concluded by the CAPM is almost as easy as it gets. It relies on no infromation. All we need, is a proxy for the market portfolio. Because of this. we would expect that no investors, regardless of how little informed, would earn less then the market portfolio returns. By doing so, they would never be subject to being taken advantage of by more experienced investors. If no one generate negative alpha, no one would generate positive alpha .
What returns will you make from holding the market portfolio?
The average returns of all investors
Average alpha of all investors is..?
zero
Does the capital asset pricing model depend on the asusmption of homogeneuos expectations?
Recall that homogenuous expectations refer to thinking the same about every stock.
The answer is no. The CAPM does not depend on this. It actually only depend on rational expectations. rational expectations refer to being rational enough to know that beating the market is a difficult task, and therefore just investing in the market portfolio. this is based on the fact that no one should really consider them selves above the average. No one should earn negative alpha, because they would get zero alpha from holding the market. This in theory leaves no room for positive alpha.
What conclusions can we say about the inefficiency of hte market portfolio?
The market portfolio will be inefficient if:
1) A significant number of investors do not have rational expectaitons so that they misinterpret and believe they are earning positive alpha when they actually earn negative alpha.
2) Care about aspects of their portfolio more than the expected return and volatility of it
how can an uninformed investor guarantee non-negative alpha?
Hold the market portfolio. the market portfolio is the average portfolio in the market, and will therefore provide average returns. With average returns follow average alpha. Average alpha is 0. 0 is non-negative.
give the multifactor model of risk
