Chapter 7 Flashcards
What are the Investor behavior assumptions of CAPM?
I.) All investors are rational mean-optimizers.
II.) Common planning horizon is one period
III.) They have homogenous expectations
What are the market structure assumptions that CAPM?
I.) All assets are publically traded and on exchanges.
II.) Investors are able to borrow at the risk free rate, and can take short positions
III.) No taxes
IV.) No transaction costs
If the CAPM assumptions hold then what are the outcomes?
I.) All investors will hold the market portfolio as their risky asset regardless of risk preference
II.) The market portfolio is on the efficient front, and the line that connects the Rf and tangency is the CML.
III.) Market Risk premium is proportional to the risk aversion and market portfolio variance.
IV.) The risk premium for an individual asset is proportional to the risk premium of the market and the beta coefficient of that security
What is the mutual fund theorem?
A conclusion of CAPM is that due to the fact that all investor needs can be satisfied by a market portfolio, therefore passive strategy is most efficient.
What does the security market line show us?
It shows the relationship between risk and return via beta and expected return.
How can an investor create cost free return?
Investing in higher alpha stocks.
Using the beta and weights of two or more assets, how are we able to calculate the portfolio beta?
By calculating the weighted Beta - (B1w1)….+(Bnwn)
If the CAPM on an asset is greater then the expected return, what do we know about this stock?
It is overpriced and a rational investor should short this stock.
If the CAPM of a stock is less then the expected return, what should an investor do?
Purchase the stock as it is underpriced.
What occurs in hypothetical equilibrium?
-all investors choose to hold the market portfolio.
-Market portfolio is on the efficient front, it is also the optimal risky portfolio
-Risk premium on market portfolio is proportional to variance of market portfolio and investors risk aversion
-Risk premium on individual assets is performed proportional to the risk premium on market portfolio, and the beta coefficient of the security
How does the SML visually represent CAPM?
It graphs individual assets as a function of expected return and beta
What does alpha show us?
It shows us the excess abnormal returns on securities, these are not guaranteed, nor an indicator of future performance
