Midterm 2 Flashcards
Studying for Exam
What is Expected Return measured by?
by mean (average)
What is Risk measured by?
by variance or standard deviation
Unsystematic Risk
unique, diversifiable risk, due to each stock’s individual risk (variance)
Systematic Risk
market, undiversifiable risk, due to + covariance among stocks (which is due to the business cycle)
Market Portfolio
contains all the risky assets in the market, and is diversified to the largest extent (contains 100% market risk)
What is the measure for systematic risk?
Beta
What does Beta measure exactly?
a stock’s tendency to move together with the market
What does the Capital Allocation Line (CAL) represent?
all possible portfolio combinations of the risky asset (A), and the risk-free asset (rf)
What does the CAL’s slope equal to?
the sharpe ratios of the portfolios
What does the Sharpe Ratio measure?
it measures the excess return for each unit of risk (also called reward-to-variability ratio)
Is choosing a CAL portfolio a technical or preference choice?
a technical choice, because you’ll always want a higher sharpe ratio, because it provides a better return with lower risk
the smaller the correlation?
the better diversification can be achieved
Minimum Variance Portfolio (MVP) occurs when:
correlation = -1 and variance/std. deviation = 0 (no risk)
What does it mean for a portfolio to be dominated?
when it’s inefficient compared to another portfolio; same risk but lower expected return
What is the efficient frontier of risky assets?
portfolios above the MVP
What is the efficient frontier of risky assets and a risk-free asset?
the tangent line (tangent portfolio = optimal risky portfolio)
The optimal risky portfolio:
has the highest sharpe ratio
Two-fund separation by Tobin
- figure out the tangent portfolio (technical process)
- choose a mix of rf and the tangent portfolio depending on risk preference (personal process)
Assumptions of CAPM
- perfect capital markets
- investors are mean-variance optimizers
- investors have same assets and can borrow at the risk-free rate
- homogeneous expectations
- single-period investment horizons
Principle Result (conclusion) of CAPM
- the market portfolio is an efficient portfolio
- given the same efficient frontier, all investors will hold the same tangent portfolio (the market portfolio)
What are the two implications of the efficiency of the market portfolio (CAPM)
- every investor is fully diversified with a mix of the market portfolio and the risk-free asset
- as risk (Beta) increases, return increases
Capital Market Line (CML)
the tangent CAL when the optimal portfolio is the market portfolio
Security Market Line (SML)
graphically represents the CAPM formula
- plotted in beta/return space
- reflects that only systematic market risk should be priced
What’re the 3 applications of CAPM?
pricing of non-traded assets, capital budgeting, and performance evaluation
