Chapter 9 CAPM Flashcards
CAPM
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)
risk-averse investors require what in order to invest
a risk premium (higher percentage, rate) to be given an incentive to accept risk
what are insurance premiums
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
risk-free asset’s return how does their sd and correlation look
they do not vary,
the standard deviation is zero
- correlation between risk free and a portfolio a is also zero
SD increase in direct what
proportion to the amount invested in the risky asset
portfolios of risky securities that lie along the efficient frontier - that is on the curve above te minimum variance portfolio are (MVP) are
efficient and dominate all other possible portfolios of risky securities
- these portfolios offer the highest expected rate of return
what is risk premium
the expected payoff that induces a risk-averse person to enter into a risky situation
Investors will only choose what portfolios
on the efficiency frontier that are above MVP
portfolios on flatter lines are what
are chosen by less risk-averse investors
portfolios higher or steeper than others
investors will require a higher return
how do investors differ
in their risk aversion
what is the formula to estimate the expected return on a portfolio
ERp = RF + W(ERa - RF)
or
ERpexpected return on portfolio that starts out with w = 0
RF - risk free rate
ERa -
the higher the portfolio allocation (weight) directed to the risky asset
the higher the portfolio risk
if w=0
this is the risk free rate or T-bill amount
Tangent portfolio - definition
the risky portfolio on the efficient frontier whose tangent line cuts the vertical axis at the risk-free rate
new (or super) efficient frontier
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
what is negative or short position
a negative position in an asset; the investor achieves a short position by borrowing part of the asset’s purchase price form the stockbroker
what is margin
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
what is the bad part about margin
the investor pays interest on the borrowed amount
- investor is called a short seller
what sort of other risks do short sellers are subject to
- experiencing unlimited losses
- risking being asked to “cover” their short position ( by purchasing the amount of shares sold)
- having to cover dividends paid on the underlying stock while they are in the short position
separation theorem
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)
what is market portfolio
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
the market portfolio is referred to as what
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
