Module 5 - Capital Asset Pricing Model (CAPM)

Question 1

What does the risk free asset act as?

Answer 1

A benchmark rate of return

Question 2

What are the three components of CAPM?

Answer 2

Beta,
Risk free rate,
Market risk.

Question 3

What does the capital allocation line do?

Answer 3

Extend the locus of feasible portfolios for an investor. As they are able to borrow funds at the risk free rate, they can use it along with their existing funds to invest in the risky assets they would have otherwise not have been able to.

Question 4

Graphically, where is the optimal risky portfolio found, and what is this point called?

Answer 4

At the point of tangency between the efficient frontier and the capital allocation line. It is called the Mean-Variance Efficient Portfolio

Question 5

What will happen to all other capital allocation lines that are not tangent to the efficient frontier?

Answer 5

They will either be impossible (if it is steeper) of inefficient (if it is flatter).

Question 6

What is the risk premium, and how is it calculated?

Answer 6

The extra return that the investors seek to hold a risky asset.

Risk premium = Rm - Rf.

Question 7

How is Sharpe’s ratio calculated?

Answer 7

Sharp Ratio = (Rm - Rf) / σm

Question 8

What does Sharpe’s ratio imply?

Answer 8

That for each percentage point increase in the risk of a portfolio along the capital allocation line, the return rises by x percentage points. It is a reward-to-risk ratio.

Question 9

What are the riskiness of the MVEP portfolio and the risk premium dependent on?

Answer 9

The risk-free rate of return. If the Rf were higher, and the same efficient frontier attainable then Sharpe’s ratio would be lower, and the MVEP held by all investors will be more risky.

Question 10

What does the MVEP include?

Answer 10

All risky assets, in proportion to their weight in the market (market capitalisation). It is therefore a scaled down version of the market itself, and is know as the market portfolio.

Question 11

Why do share prices fluctuate?

Answer 11

1) They move with the market - market related or systematic risk
2) Idiosyncratic reasons - specific or unsystematic risk.

Question 12

How do you calculate the return on a share in a given time period?

Answer 12

𝑅𝑖𝑡 = ∝𝑖 +𝛽𝑖 𝑅𝑚𝑡 + 𝜖𝑖𝑡
= a constant term + beta of i * return on the market portfolio, m, in period t + specific risk.

Question 13

How do you calculate market risk?

Answer 13

𝛽𝑖 * 𝑅𝑚𝑡