chapter 2 part 2 CAPM and types of risk

Question 1

portfolio effect

Answer 1

an attempt to reduce investing risk by ‘not putting all your eggs into one basket’

holding portfolios of securities

Question 2

systematic risk

Answer 2

also known as market risk

CANNOT BE ELIMINATED BY DIVERSIFICATION

changes in macroeconomic variables 
e.g. 
Recession
Interest rates
Exchange rates
Taxation
Inflation
changes in taxation

Question 3

Unsystematic risk

Answer 3

CAN BE ELIMINATED THROUGH DIVERSIFICATION

relates to factors that affect the returns on investments in unique ways (e.g. risk that a particular firms labour force goes on strike)

a diversified portfolio of 15-20 securities will eliminate the vast majority of unsystematic risk

Question 4

Unsystematic risk

Answer 4

CAN BE ELIMINATED THROUGH DIVERSIFICATION

relates to factors that affect the returns on investments in unique ways (e.g. risk that a particular firms labour force goes on strike)

a diversified portfolio of 15-20 securities will eliminate the vast majority of unsystematic risk

Question 5

CAPM definition and formula

Answer 5

measures systematic risk of investments and its returns

systematic risk measured as an index, beta (B). beta of a security measures the sensitivity of returns on the security to changes in systematic factors

B=0 is a risk free security
B=1 is average market risk
B>1 investment more affected by changes in macroeconomic variables

formula : rj= rf + Bj ( rm-rf)

rj = required rate of return on investment j
rf=risk free rate of interest
rm=return on market portfolio
Bj= index of systematic risk for security j

(rm-rf) = risk free premium

formula given in exam

note when to do with shares rj = cost of equity capital Ke

Question 6

aggressive and defensive shares and application of CAPM in project appraisal

Answer 6

aggressive shares - high beta
defensive shares - low beta

buy aggressive shares if bull market (expected to rise)

buy defensive shares is bear market (expected to fall)

CAPM used to set minimum required returns (ie risk adjusted discount rates) for new capital projects

advantage is it clearly shows that the discount rate should be related to a projects risk

Question 7

Weaknesses of CAPM

Answer 7

• companies shareholders may not be DIVERSIFIED (eg in small company may have invested most funds into one company)
• shareholders not only participants, directors and employees are exposed to risks so may try to diversify
• CAPM depends on perfect capital market
• the need to determine excess return (rm-rf). excess rather than historical should be used, however historical often used in practice.
• the need to determine risk free rate
• errors in statistical analysis used to calculate beta values, betas may change over time
• CAPm unable to accurately forecast returns for companies with low price/earnings ratios and unable to take account of seasonal and day of the week effects on shares

Question 8

Alternatives to CAPM : Alpha value

Answer 8

seen as a measure of how wrong the CAPM model is. it:
-reflects only temporary, abnormal returns, if capm is a realistic model
-