Module 9: Investment Management

Question 1

What can CAPM be used for in investment management?

Answer 1

Capital Asset Pricing Model (CAPM) is a formula for predicting
the required rate of return for an investment, based upon its level of systematic risk relative
to that of the market as a whole. It can be used to calculate a cost of equity that
incorporates risk. This cost of equity can then be used for establishing the ‘correct’
equilibrium market value of a company’s shares.

Question 2

What is that CAPM formula?

Answer 2

E(ri) = rf + i(rm – rf)
where:
-E(ri) is the required or expected return from a security.
-rf is the risk-free rate of return.
rm is the return from the market as a whole.
-i is the beta factor of the individual security.

Question 3

When does the correlation coefficient for two investments measure?

Answer 3

The relationship between the returns from different investments is measured by the correlation
coefficient. A figure close to +1 indicates high positive correlation, and a figure close to –1 indicates
high negative correlation. A figure of 0 indicates no correlation.

Question 4

What is the impact of financial leverage?

Answer 4

The impact of financial leverage or gearing is that by borrowing at the risk-free rate the investor can
increase the available return on his portfolio. Investors can also increase the returns available on their portfolio by selling one asset short (effectively
taking out a risky loan) and using the funds generated to invest more than their original capital, in an
alternative asset which generates a higher return. This strategy is unlikely to be preferred by more risk averse investors since short selling involves the potential for large losses if the market rises instead of
falls.
Note: short selling involves the investor selling an asset that they do not own at the time of sale, which generates cash, in the expectation that the market will fall and they can purchase the asset at a lower price in the future. This both fulfils the transaction and results in a profit.

Question 5

What is the efficient frontier?

Answer 5

The efficient frontier shows a collection of optimal portfolios for a rational, risk averse investor: either
the best return that can be expected for a given level of risk or the lowest level of risk needed to
achieve a given expected rate of return.

Question 6

What is the market portfolio

Answer 6

The market portfolio is a hypothetical portfolio containing every security available
to investors in a given market, in amounts proportional to their market values.