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2nd Year - Finance 1 > Lecture 9 - Capital Asset Pricing Model > Flashcards

Lecture 9 - Capital Asset Pricing Model Flashcards

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1
Q

What is market portfolio?

A

Portfolio of all assets in the economy. In practice a broad stock market index is used to represent the market.

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2
Q

If the market is up on a particular day, then the net impact must be…

A

Positive.

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3
Q

What is Beta?

A

Sensitivity of a stock’s return to the return on the market portfolio.

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4
Q

Wise investors…

A

Reduce their risk by diversification.

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5
Q

Diversification can eliminate the risk that is unique to individual stocks but not…

A

The risk that the market as a whole may decline, carrying your stocks with it.

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6
Q

What are defensive stocks?

A

They are not very sensitive to market fluctuations and therefore, have low betas. Betas are less than 1. The returns of these stocks vary less than one for one with market returns.

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7
Q

What are aggressive stocks?

A

These stocks amplify any market movements and have higher betas. Betas greater than 1. Their returns tend to respond more than one for one to returns on the overall market.

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8
Q

What is the average beta of all stocks?

A

1 exactly.

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9
Q

Common stock returns can be broken down into two parts. What are they?

A

The part explained by market returns and the firm’s beta (fluctuation in this part reflect market risk). The part due to news that is specific to the firm (fluctuations in this part reflect specific risk). Diversification can get rid of specific risk.

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10
Q

Explain the Beta for Ford.

A

Ford outperformed the market when index rose and underperformed the market when index fell. Ford was an aggressive, high beta stock. A wider scatter means more firm specific risk.

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11
Q

Explain the Beta for PG&E.

A

PG&E was a defensive, low beta stock.

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12
Q

Total risk is not…

A

The same as market risk.

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13
Q

Firm specific risk, is of course, diversifiable and of no concern to…

A

An investor tracking the performance of his or her well diversified portfolio.

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14
Q

What is the beta of a portfolio?

A

Just an average of the betas of the individual securities in the portfolio, weighted by the investment in each security.

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15
Q

What is portfolio beta?

A

(Fraction of portfolio in stock 1 x Beta of stock 1) + (Fraction of portfolio in stock 2 x Beta of stock 2)

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16
Q

Total risk is equal to…

A

Systematic risk + unsystematic risk.

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17
Q

The standard deviation of returns is a measure of…

A

Total risk of a diversified portfolio.

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18
Q

For well diversified portfolios…

A

Unsystematic risk is very small.

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19
Q

The total risk for a diversified portfolio is essentially…

A

Equivalent to the systematic risk.

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20
Q

Diversification decreases variability from unique risk but…

A

Not from market risk.

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21
Q

A fully diversified portfolio, including all stocks, will match the market and so have a beta of…

A

1.0 and the same standard deviation as the market.

22
Q

A wise and diversified investor does not judge the risk of individual stocks by their stand alone volatility, but by…

A

Their contributions to portfolio risk.

23
Q

Why is US Treasury bills the least risky investment?

A

The return on Treasury bills are fixed, it is unaffected by what happens to the market.

24
Q

What is the beta of Treasury bills?

A

Zero.

25
Q

What is the riskiest investment?

A

Common stocks. This has average market risk. Its beta is 1.0.

26
Q

What is market risk premium?

A

Risk premium of market portfolio. Difference between market return and return on risk free Treasury bills.

27
Q

What is the capital asset pricing model?

A

Theory of the relationship between risk and return stating that the expected risk premium on any security equals its beta times the market risk premium.

28
Q

What does the CAPM interpret?

A

The expected rates of return demanded by investors depend on two things; 1) compensation for the time value of money (the risk free rate, rf) and 2) a risk premium, which depends on beta and the market risk premium.

29
Q

What does CAPM assume?

A

That the stock market is composed of well diversified investors - investors operating at the bottom of the portfolio risk curves.

30
Q

What is the security market line?

A

Relationship between expected return and beta.

31
Q

What does the security market line describe?

A

The expected returns and risks from splitting your overall portfolio between risk free securities and the market. It also sets a standard for other investments. Investors will be willing to hold other securities only if they offer equally good prospects. Thus, the required risk premium for any investment is given by the security market line.

32
Q

A lower stock price means a better buy for investors - that is…

A

A higher expected rate of return.

33
Q

Investors will demand that each security provides…

A

An expected rate of return that matches the expected rate of return they can obtain on equal beta portfolios constructed from the market index and Treasury bills. Hence why the CAPM makes sense and why the expected risk premium that investors demand from an investment should be proportional to its beta.

34
Q

Underpriced stocks…

A

Are above the security market line.

35
Q

Overpriced stocks…

A

Are below the security market line.

36
Q

How good is CAPM in estimating expected returns?

A
  • Betas are estimates, not exact measurements.
  • Very high or low betas tend not to repeat in the future.
  • It is difficult to pin down the expected future market risk premium.
  • While the CAPM is widely used in practice, it is not the last word in risk and return in the stock market.
37
Q

What is the basic idea behind CAPM?

A

Investors expect a reward for waiting and worrying. The greater the worry, the greater the expected return. If you invest in a risk free Treasury bill, you just receive the rate of interest. That is the reward for waiting. When you invest in risky stocks, you demand an extra return or risk premium for worrying. When risk is higher, investors will not be willing to pay as much for shares of stock, and the price will fall until the rate of return they can expect to earn provides a ‘fair’ expected risk premium. The capital asset pricing model states that this risk premium is equal to the stock’s beta times the market risk premium.

38
Q

What does the CAPM predict?

A

It predicts that the risk premium should increase in proportion to beta, so the returns of each portfolio should lie on the upward sloping security market line.

39
Q

High beta portfolios generate…

A

Higher returns.

40
Q

What are value stocks?

A

Those with high ratios of book value to market value.

41
Q

What are growth stocks?

A

Those with low ratios of book to market stocks.

42
Q

The superior performance of small firm stocks and value stocks does not fit well with the CAPM, which predicts…

A

That beta is the only reason that expected returns differ. If investors expected the returns to depend on firm size or book-to-market ratios, then the simple version of the capital asset pricing model cannot be the whole truth.

43
Q

What are the fundamental ideas that are captured by the CAPM?

A

Almost everyone agrees that investors require some extra return for taking on risk.
Investors appear to be concerned principally with the market risk that they cannot eliminate by diversification.

44
Q

What are the assumptions behind CAPM?

A
  • Investment in US Treasury bills is risk free.

- Investors can borrow money at the same interest at which they can lend.

45
Q

What is the project cost of capital?

A

The discount rate for valuing a proposed capital investment project should be the opportunity cost of capital, defined as the expected rate of return that the company’s shareholders could achieve by investing on their own. However, the CAPM tells us that expected rates of return depend on risk, so beta. Therefore, the opportunity cost of capital for a proposed project should depend on the project’s beta. The project cost of capital is therefore, its minimum acceptable expected rate of return, given its risk.

46
Q

Where are high beta portfolio plotted in terms of the SML?

A

Below the SML.

47
Q

Where are low beta portfolios plotted in terms of the SML?

A

Above the SML.

48
Q

If the CAPM holds, the security market line defines the…

A

Opportunity cost of capital. If a project’s expected rate of return plots above the security market line then it offers a higher expected rate of return than investors could get on their own at the same beta.

49
Q

What does the cost of capital depend on?

A

The use to which the capital is put. It depends on the risk of the project not on the risk of the company investing in the project. If a company has a low risk project, it should discount project cash flows at a correspondingly low rate. If a company has a high risk project, it should discount at a correspondingly high rate.

50
Q

What is the company cost of capital?

A

Opportunity cost of capital for investment in the firm as a whole. The company cost of capital is the appropriate discount rate for an average risk investment project undertaken by the firm. Many companies use the company cost of capital for all capital investment projects, which is fine provided that all projects are close enough to average risk. Others set the company cost of capital as a benchmark and adjust the discount rate up or down for riskier or safer projects.

51
Q

Cyclical businesses, whose revenues and earnings are strongly dependent on the state of the economy, tend to have…

A

High betas and a high cost of capital.

52
Q

By contrast, businesses that produce essentials, such as food, beer, and cosmetics, are less affected by the state of the economy. They tend to have…

A

Low betas and a low cost of capital.

2nd Year - Finance 1 (10 decks)

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