Exam 2 - Chapter 7 [BOOK] Flashcards
capital asset pricing model (CAPM)
A model that relates the required rate of return on a security to its systematic risk as measured by beta.
market portfolio (M)
The portfolio for which each security is held in proportion to its total market value.
mutual fund theorem
States that all investors desire the same portfolio of risky assets and can be satisfied by a single mutual fund composed of that portfolio.
expected return–beta relationship
Implication of the CAPM that security risk premiums should be proportional to beta
security market line (SML)
Graphical representation of the expected return-beta relationship of the CAPM.
alpha
The abnormal rate of return on a security in excess of what would be predicted by an equilibrium model such as the CAPM.
multifactor models
Models of security markets positing that returns respond to several systematic factors.
arbitrage
Creation of riskless profits made possible by relative mispricing among securities.
arbitrage pricing theory (APT)
A theory of risk-return relationships derived from no-arbitrage considerations in large capital markets.
well-diversified portfolio
A portfolio sufficiently diversified that nonsystematic risk is negligible.
factor portfolio
A well-diversified portfolio constructed to have a beta of 1 on one factor and a beta of 0 on any other factor.
The CAPM assumes
investors are rational, single-period planners who agree on a common input list from security analysis and seek mean-variance optimal portfolios.
The market portfolio is
value-weighted.
The risk premium on the market portfolio
is proportional to its variance, image, and to the risk aversion of the average investor.
The CAPM implies that the risk premium on any individual asset or portfolio
is the product of the risk premium of the market portfolio and the asset’s beta.
The security market line shows the
return demanded by investors as a function of the beta of their investment.
This expected return is a benchmark for
for evaluating investment performance.
The intercept of the SCL, called ____, represents the average excess return on the security when the index excess return is ____. The CAPM implies that alphas should average ___.
alpha; zero; zero
The CAPM and the security market line can be used to establish benchmarks for evaluation of investment performance or to determine appropriate discount rates for capital budgeting applications. They are also used in
regulatory proceedings concerning the “fair” rate of return for regulated industries.
The CAPM is usually implemented as a _________, with all systematic risk summarized by the return on a broad market index.
single-factor model
There are two general approaches to finding extra-market systematic risk factors.
One looks for factors that are empirically associated with high average returns and so may be proxies for relevant measures of systematic risk. The other focuses on factors that are plausibly important sources of risk to wide segments of investors and may thus command risk premiums.
An arbitrage opportunity arises
when the disparity between two or more security prices enables investors to construct a zero net investment portfolio that will yield a sure profit.
The presence of arbitrage opportunities and the resulting volume of trades will create pressure on
security prices that will persist until prices reach levels that preclude arbitrage.
Only a few investors need to become aware of arbitrage opportunities
to trigger this process because of the large volume of trades in which they will engage
When securities are priced so that there are no arbitrage opportunities, the
market satisfies the no-arbitrage condition.
Price relationships that satisfy the no-arbitrage condition are important because
we expect them to hold in real-world markets.
Portfolios are called well diversified if they include a
large number of securities in such proportions that the residual or diversifiable risk of the portfolio is negligible.
In a single-factor security market, all well-diversified portfolios must satisfy ________ in order to satisfy the no-arbitrage condition.
the expected return–beta relationship of the SML
If all well-diversified portfolios satisfy the expected return–beta relationship, then all but a ____ _____ of securities also must satisfy this relationship.
small number
The APT implies the same expected return–beta relationship as the CAPM yet does not require ______ The price of this generality is that the APT does not guarantee this relationship for all securities at all times.
that all investors be mean-variance optimizers.
A multifactor APT generalizes the
single-factor model to accommodate several sources of systematic risk.
