Midterm #2 Flashcards
2 Types of Risk
Firm Specific
Macroeconomic
Covariance
measures the extent to which the returns on any two assets vary in tandem
Index Model
statistical model designed to estimate the two risk components of a security or portfolio
practicability is key
alpha
measures the excess return (or underperformance) of a stock or portfolio relative to a benchmark index, after accounting for market-related risk (Beta). It reflects the value added (or lost) by the asset manager or stock independent of the market
+ alpha
outperformed
Beta
measures the sensitivity of a stock or portfolio’s returns to the returns of the market. It represents the level of systematic risk (market risk) associated with an asset.
Beta < 1
less volatile than the market
Beta = 1
in line with market
Beta > 1
more volatile than the market
tech stocks
CAPM
Capital Asset Pricing Model
model that produces a precise relationship between the risk of an asset and its expected return
provides a benchmark rate of return
Investors only differ
in risk aversion
Market Portfolio
the sum of the portfolios of all investors
Alpha and Single Index
is the stock’s return not explained by the market
Risk Aversion
does not matter for finding the optimal risk portfolio
Passive Indexing Strategy
obtain efficient portfolio by simply holding the market portfolio
Optimal Risky Portfolio of All Investors
is the same
CAPM provides
a baseline for providing securities
Alpha =
expected return - fair return
Expected Returns should
be directed related to beta
CAPM deals with
MARKET not investor
Firm Specific Stocks are
independent of market movements
so independent of alpha
Alpha and Stocks
doesn’t necessarily mean higher firm-specific shocks—it means the stock has a higher expected return UNRELATED to the market.
Systematic Risk and Beta
Firm-specific shocks are unsystematic risk, and their standard deviation is independent of beta.
Expected Value of Firm Specific Stocks
is zero because they are random and unpredictable. Over time, the positive and negative deviations cancel out
While the stocks have the same alpha, beta, and firm-specific standard deviation
their returns are not always the same
Diversification and Beta
Diversification does not lower beta
it reduces unsystematic risk
Diversification and Alpha
does not increase Beta
it reduces risk
Diversification between Stocks
will yield a lower variance portfolio
Systematic
market
Unsystematic
unique to a specific company
Low p value in sigle index model regression
stock’s true alpha is likely equal to zero
Alpha = 0
in line with market
Markowitz Portfolio
focuses on identifying the optimal risky portfolio by minimizing risk for a given level of expected return
more accurate compared to single index
Single Index Model
simplifies portfolio construction by assuming that all stock returns are influenced by a single common factor
If CAPM holds
zero alpha
If CAPM holds what determines the stocks expected return
stock’s beta
X Plot
market excess return
Y Plot
stock’s excess return for that month
When the point is to the right and below
shows that the market went up and the stock went down
What is the Beta on the Graph?
the slope of the line
Each Dot
is a 1 month return
Where is Alpha?
the intercept
Expected on the Graph
is the distance between the slope and the plot
When the plot is more spread out
it has more firm specific risk
Market Portfolio in the CAPM
has a beta of 1
In Single Index Model the expected value of firm specific stocks is
0
Beta of 1.2
expected return will be higher than the market return
Diversification in the Single Index Model
reduces firm specific risk
DOES NOT eliminate systematic risk
CAPM Beta of 0 =
Risk Free Rate
Alpha in Index Model
is expected excess return after controlling for systematic risk
