Chapter 9 CAPM

Question 1

CAPM

Answer 1

helps to answer the question what premium should this investment be so that it can be a competitive investment compared to other investments (cost of equity)

Question 2

risk-averse investors require what in order to invest

Answer 2

a risk premium (higher percentage, rate) to be given an incentive to accept risk

Question 3

what are insurance premiums

Answer 3

investors pay this insurance premium to get out of risky situations, therefore we conclude that investors will only choose portfolios tha tare members of the efficient frontier

Question 4

risk-free asset’s return how does their sd and correlation look

Answer 4

they do not vary,
the standard deviation is zero
- correlation between risk free and a portfolio a is also zero

Question 5

SD increase in direct what

Answer 5

proportion to the amount invested in the risky asset

Question 6

portfolios of risky securities that lie along the efficient frontier - that is on the curve above te minimum variance portfolio are (MVP) are

Answer 6

efficient and dominate all other possible portfolios of risky securities
- these portfolios offer the highest expected rate of return

Question 7

what is risk premium

Answer 7

the expected payoff that induces a risk-averse person to enter into a risky situation

Question 8

Investors will only choose what portfolios

Answer 8

on the efficiency frontier that are above MVP

Question 9

portfolios on flatter lines are what

Answer 9

are chosen by less risk-averse investors

Question 10

portfolios higher or steeper than others

Answer 10

investors will require a higher return

Question 11

how do investors differ

Answer 11

in their risk aversion

Question 12

what is the formula to estimate the expected return on a portfolio

Answer 12

ERp = RF + W(ERa - RF)

or
ERpexpected return on portfolio that starts out with w = 0
RF - risk free rate
ERa -

Question 13

the higher the portfolio allocation (weight) directed to the risky asset

Answer 13

the higher the portfolio risk

Question 14

if w=0

Answer 14

this is the risk free rate or T-bill amount

Question 15

Tangent portfolio - definition

Answer 15

the risky portfolio on the efficient frontier whose tangent line cuts the vertical axis at the risk-free rate

Question 16

new (or super) efficient frontier

Answer 16

portfolios composed of the risk-free rate and the tangent portfolio that offer the highest expected rate of return for any given level of risk

Question 17

what is negative or short position

Answer 17

a negative position in an asset; the investor achieves a short position by borrowing part of the asset’s purchase price form the stockbroker

Question 18

what is margin

Answer 18

means the investor borrows part of the purchase price from the stockbroker
ex.
some stocks have margin requirements as low as 30%, indicating an investor could buy $1,000 worth of stocks by investing only $300 and borrowing the reaming $700 form the broker
- in this case, the portfolio weights are w = 1,000 / 300 or 333% in the risky asset and -233% in the risk-free asset

Question 19

what is the bad part about margin

Answer 19

the investor pays interest on the borrowed amount

- investor is called a short seller

Question 20

what sort of other risks do short sellers are subject to

Answer 20

1. experiencing unlimited losses
2. risking being asked to “cover” their short position ( by purchasing the amount of shares sold)
3. having to cover dividends paid on the underlying stock while they are in the short position

Question 21

separation theorem

Answer 21

the theory that the investment decision (how to construct the portfolio of risky assets) is separate form the financing decision (how much should be invested or borrowed at the risk-free rate)

Question 22

what is market portfolio

Answer 22

a portfolio that contains all risky securities in the market

• theoretically should contain all risky assets worldwide, including stocks, bonds, options, futures, gold, real estate etc. in their proper proportions
• such a portfolio would be completely diversified
• not real
• use market indexes, such as the S & P / TSX and S&P 500 used to measure its behaviour

Question 23

the market portfolio is referred to as what

Answer 23

an equilibrium condition
because supply equals demand for all the risky securities, and we place T with M, which is not the tangent portfolio but also the market portfolio