Lecture 11

Question 1

What are the seven assumptions underlying the CAPM?

Answer 1

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

Question 2

What is the CAPM equation?

Answer 2

E(Ri) = rf + (cov(Ri, Rm) / Var(Rm)) * (E(Rm) - rf)

Question 3

Beta > 1 is considered aggressive and Beta < 1 is considered defensive

Question 4

What is the difference between volatility and beta as risk indicators?

Answer 4

Beta only considers systematic risk of the market because idiosyncratic risk can be diversified away to the efficient frontier.
Volatility considers total risk.

Question 5

What is alpha in the CAPM world?

Answer 5

The difference between the CAPM expected return and actual return.

Question 6

What is beta?

Answer 6

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.

Question 7

What is the Security Market Line?

Answer 7

The line that shows the relationship between return and beta

Question 8

What is the difference between CML and SML?

Answer 8

CML uses sigma as risk indicator and SML uses beta as risk indicator.

Question 9

What are the three pillars of a valuation triangle in every asset pricing model?

Answer 9

Price now
Price in the future + dividends
Expected return

Question 10

What are two ways to empirically test CAPM?

Answer 10

1. In the equation; (Ri - Rf) = Alpha + Beta (Market Risk Premium) + Error Term, according to CAPM, Alpha should be zero.
2. Cross-sectional regressions. According to CAPM, the returns and their betas should be linearly related. Test for a linear relationship. (Fama-French)

Question 11

What did Fama and French found in their CAPM research?

Answer 11

Beta is dead. They found no systematic relationship in their research, therefore Beta is not the correct explanatory variable to explain variance in returns.

Question 12

What variables does the Fama French model use?

Answer 12

Beta, size and book-to-market

Question 13

What is the book-to-market ratio?

Answer 13

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.

Question 14

What is the only effect that the Fama French model does not explain?

Answer 14

Momentum effect