Lecture 2

Question 1

Capital asset pricing model

Answer 1

CML depicts the linear relationship between expected return and total risk of fully-diversified portfolios.

I

Question 2

Assumptions of the capital asset pricing models

Answer 2

Mean-variance efficient investors
Borrow and lend at the risk free rate of interest
Investors are homogenous
Investors are infinitely divisible
No tax and transaction costs
Capital markets are in equilibrium (assets are priced in line with their risks)

Question 3

Relationship between risky assets and expected return

Answer 3

A linear relationship exists between risky assets expected returns and their systematic risk

Question 4

Negative betas

Answer 4

They might exist
Assets with negative betas:
- give returns lower than returns of risk free assets
- provide a form of insurance against the market’s movement.

Question 5

Asset mis-priced

Answer 5

• mis-pricing occurs if an asset lies above or below the security market line, in which case the investment incurs an abnormal return.

Question 6

Two major components of market beta are:

Answer 6

Two major components of market beta are:

• business risk = uncertainties relating to the firm’s reasons assets
• financial risk = uncertainties relating to the firm’s capital structure

All the firm-specific characteristics that affect market beta fall into either business risk or financial risk

Question 7

Beta and operating leverage

Answer 7

A firms operating leverage measures the degree to which a firm can increase operating income by increasing revenue (business risk factor)

Question 8

Revenues is driven by market demand for the company’s output earnings elasticity to demand?

Answer 8

P(unit price)-V(unit variable cost)
E = contribution margin
Operating leverage is high when E is large and vice Versa

Question 9

Operating leverage is directly related to the cost structure.
Operating leverage?

Answer 9

Fixed Cost/Total Cost 
Capital intensive firms maintain high fixed cost relative to variable cost = high operating leverage 
If V (unit variable cost) decreases relative to F (higher operating leverage) = E increases

Question 10

Anomalies against CAPM

Answer 10

Firm size: small firms outperform large firms
Book to Market Value Ratio: value stocks outperform growth stocks
Earnings elasticity to demand/unit price (P) : high E/P stocks outperform low E/P stocks
Financial leverage: high levered firms outperform low-levered firms
CAPM is unable to explain the anomalies

Question 11

The size effect

Answer 11

• small firms, particularly very small firms, give higher risk-adjusted returns than large firms,
  -portfolios formed by firm size
  10 Portfolios are high beta portfolios

Question 12

The value effect

Answer 12

Value stocks give higher risk-adjusted expected returns than growth stocks
The market price per share/book value per share indicates the prospect of growth opportunities in a firm perceived by investors.
-value stocks have high ME/BE
-growth stocks have low BE/ME

Question 13

The Fama-French Three Factor Model

Answer 13

An empirical asset pricing model by fama and French
Failure of CAPM beta:
- the major explanatory power of expected returns in US firms is attributable to:
-firm size and BE/ME ratio
- BE/ME includes the effects of E/P and leverage on expected returns.