Module 53.2: The CAPM and SML Flashcards
What is the best measure of systematic risk of an asset?
covariance of the returns of asset and the market
What is the security market line? What is the equation?
the graphed line that illustrated systematic risk of an asset
= rf + [ (expected return on market - risk free rate) / variance of market ] * covariance asset, market
or
= rf + [Cov asset, market / variance of market ] * (expected return market - risk free rate)
What is the formula for capital asset pricing model (CAPM)
expected return = rf + beta (expected return market - risk free rate)
What are the 7 assumptions of the CAPM model?
1) risk aversion - higher risk, higher return required
2) utility maximizing investors - investors pick portfolio that maximize their utility
3) frictionless markets - no taxes, transaction costs, or other impediments
4) one-period horizon - all investors have same 1 period horizon
5) homogeneous expectations - same expectations for asset returns
6) divisible assets - all investments are infinitely divisible
7) competitive markets - take market price as given
What is the equation for the CML?
expected return portfolio = risk free + standard deviation of asset * [ (expected return of market - risk free rate) / standard deviation of market ]
what is the major difference between the CML and the SML (security market line)
CML uses total risk = standard deviation. SML uses beta (systematic risk) on the x-axis.
Does low beta mean low risk stock?
not necessarily when total risk is considered.
What is implied when portfolios do not lie on the CML?
they are inefficient and not being rewarded with the same return for the amount risk they’re taking on.
If the stock expected return / beta lands above the SML or below the SML what does that imply?
if the stock plots over the SML, the secuity is under valued.
If the stock plots under the SML, the securtiy is over valued.
What is attribution analysis? Why can you not just compare the returns of an active portfolio with a passive one?
sources of returns differences between active portfolio returns and those of a passive benchmark portfolio.
cannot just compare returns because risk taken to achieve returns must also be considered.
WHat is the sharpe ratio? What is the formula?
a portfolios excess returns per unit of total portfolio risk. higher sharpe ratios indicate better risk-adjusted portfolio performance.
= (expected return of the portfolio - risk free rate) / standard deviation of portfolio
Note sharpe ratio can be used to evaluate the performance of portfolios with systematic and unsystematic risk (because standard deviation is used)
What is the m^2 measure of a portfolio? what is the formula?
same as sharpe ratio, but measured in percentage.
=(return of portfolio - risk free return) * (standard deviation of market / standard deviation of portfolio) * return of market - risk free rate)
m^2 is considered a risk-adjusted performance measure (RAP). the intuition is that m^2 is the additional return that could have been earned by leveraging the active portfolio at risk free rate.
What is the Treynor measure and Jensen’s alpha?
treynor & jenson - analogous to sharpe and m^2.
treynor = return of portfolio - risk free rate / beta of portfolio
jensen = return of portfolio - [risk free rate + beta portfolio (return of market - risk free rate)
When should an investor use sharpe and m^2 rather than treynor and jensens alpha?
when the portfolio is not well diversified, single manager - unsystematic risk exsits, so sharpe and m^2 should be used.
treynor and jensens should be used when the portfolio is well diversified.
Would an investor prefer a lower or higher sharpe ratio?
Higher the better, assuming investors like return and not risk.
