Lecture 11 Flashcards
What are the seven assumptions underlying the CAPM?
Individual investors are price takers.
Single period investment horizon
Only financial assets are traded
No taxes and transaction costs
Information available to all investors
Investors are rational mean-variance optimizers
Homogeneous expectations
What is the CAPM equation?
E(Ri) = rf + (cov(Ri, Rm) / Var(Rm)) * (E(Rm) - rf)
Beta > 1 is considered aggressive and Beta < 1 is considered defensive
What is the difference between volatility and beta as risk indicators?
Beta only considers systematic risk of the market because idiosyncratic risk can be diversified away to the efficient frontier.
Volatility considers total risk.
What is alpha in the CAPM world?
The difference between the CAPM expected return and actual return.
What is beta?
Covariance of asset I with the market divided by the variance of the market. Beta is how much exposure an asset has with the market risk.
What is the Security Market Line?
The line that shows the relationship between return and beta
What is the difference between CML and SML?
CML uses sigma as risk indicator and SML uses beta as risk indicator.
What are the three pillars of a valuation triangle in every asset pricing model?
Price now
Price in the future + dividends
Expected return
What are two ways to empirically test CAPM?
- In the equation; (Ri - Rf) = Alpha + Beta (Market Risk Premium) + Error Term, according to CAPM, Alpha should be zero.
- Cross-sectional regressions. According to CAPM, the returns and their betas should be linearly related. Test for a linear relationship. (Fama-French)
What did Fama and French found in their CAPM research?
Beta is dead. They found no systematic relationship in their research, therefore Beta is not the correct explanatory variable to explain variance in returns.
What variables does the Fama French model use?
Beta, size and book-to-market
What is the book-to-market ratio?
Compares a company’s net asset value or book value to its current or market value. If the company’s market value is trading higher than its book value per share, it is considered to be overvalued. If the book value is higher than the market value, the company is considered to be undervalued.
What is the only effect that the Fama French model does not explain?
Momentum effect
