Lecture 5

Question 1

What is the key implication of CAPM?

Answer 1

Question 2

What are some assumptions under CAPM that are easily violated?

Answer 2

**Identical input lists (homogenous expectations): **

Assumption - All investors have the same expectations about asset returns, variances, and covariances.

Violation - Investors differ in their expectations due to different information or interpretations.

This heterogeneity in expectations can lead to mispricings, creating opportunities for active strategies.

Short positions are allowed:
Assumptions - Investors can freely sell stocks they do not own (short selling).

Violation - Short selling may be restricted or costly, leading to overpricing in markets because investors with negative views cannot fully express their positions.

Investors can borrow and lend at the risk-free rate
Violation: In reality, borrowing rates are higher than the risk-free rate due to credit risks and constraints. This leads to leverage constraints, limiting investors’ ability to take on desired positions.

No transaction costs
Violation: Illiquid markets or high transaction costs prevent instantaneous adjustment of prices, creating illiquidity risk.

Question 3

What is the premise of active investing?

Answer 3

Generate alpha by doing security analysis

Question 4

Please outline the top-down and bottom-up approaches

Answer 4

“Top-down” approach: (1) macroeconomic analysis to determine
attractive markets, (2) within the prosperous market, select “the best”
industry, (3) within the industry, invest in attractively priced securities.

“Bottom-up” approach: buy underpriced and sell overpriced stocks based on equity valuation

Question 5

Dividend discount model

Answer 5

Question 6

Constant growth DDM, formula and outline implications of k

Answer 6

Question 7

Please explain the impact of the plowback ratio on dividends

Answer 7