FINA211 WK11 L22 Capial Asset Pricing Model (CAPM) Flashcards
What is the capital asset pricing model (CAPM)?
CAPM is a financial model that calculates the expected rate of return for an asset or investment.
CAPM does this by using the expected return on both the market, and a risk-free asset, and the asset’s correlation or sensitivity to the market, called beta.
What is the formula for calulating the expected return of an asset using CAPM?
ER.i = R.f + Bi(ER.m - R.f)
where
ER.i = expected return of investment
R.f = risk fee rate
B.i = beta of the investment, the asset’s correlation or sensitivity to the market
ER.m = expected return on the market
(ER.m - R.f) = market risk premium
What is the expected value (EV)?
The expected value (EV) is the anticipated average value for an investment at some point in the future.
In statistics and probability analysis, the expected value is calculated by multiplying each of the possible outcomes by the likelihood each outcome will occur and then summing up all of those values.
What is the formula for expected value (EV)?
EV = sum(P(X)*X)
where
X = random variable
P(X) = probability of X
What is the formula for expected value for the return of a stock?
EV = sum(P(return)*return)
where
return = expected return
P(return) = probability of expected return
What is the formula for weighted expected value for the return of a stock?
EV.weighted = sum(weightP(return)return)
What is the standard variantion for the return of a stock?
theta = sqrt(sum((observed return - expected value)^2)^(1/2))
theta = sum((observed return - expected value)^2)^(1/2)
What is the formula for co-variance of the returns of two stocks?
COV(returns.A, returns.B) = sum((observed return.A - expected value.A)*(observed return.B - expected value.B)^2)
What is the formula for the standard deviation of two the returns of two stocks?
COV(returns.A, returns.B) = sum((observed return.A - expected value.A)*(observed return.B - expected value.B)^2)
What is the formula for the
COV(returns.A, returns.B) = sqrt(sum((observed return.A - expected value.A)(observed return.B - expected value.B)^2))
COV(returns.A, returns.B) = (sum((observed return.A - expected value.A)(observed return.B - expected value.B)^2))^1/2
What are unsystematic risks?
Unsystematic risks are risks that are specific to a company or industry.
What is are systematic risks?
Systematic risk are risks tied to the broader market.
What is the purpose of diversifying a stock portfolio?
The pupose of diversifying a stock portfolio is to mitigate risk.
What type of risk can be diversified away/what type of risk cannot be diversified away?
Unsystematic risks can be diversified away by investing in stocks of different companies and companies in different industries.
Systematic risk cannot be diversified away because they are tied to the broader market and therefore affect all companies and industries, so investors need to be compensated for taking on this risk.
Why do investors need to be compensated for systematic risk?
Systematic risk cannot be diversified away because they are tied to the broader market and therefore affect all companies and industries, so investors need to be compensated for taking on this risk.
