Reading 53: Portfolio Risk and Return: Part II Flashcards
Identify the practical limitations of CAPM.
A true market portfolio is unobservable as it would also include assets that are not investable.
In the absence of a true market portfolio, the proxy for the market portfolio used varies across analysts, which leads to different return estimates for the same asset.
Describe Jensen’s alpha.
Jensen’s alpha is based on systematic risk (like the Treynor ratio). It first estimates a portfolio’s beta risk using the market model, and then uses CAPM to determine the required return from the investment (given its beta risk). It is the difference between the portfolio’s actual return and the required return (as predicted by the CAPM).
Explain the capital allocation line (CAL) and the capital market line (CML).
A capital allocation line (CAL), includes all combinations of the risk-free asset and any risky asset portfolio. The capital market line (CML) is a special case of the capital allocation line where the risky asset portfolio that is combined with the risk-free asset is the market portfolio.
Describe statistical factor models.
Statistical factor models use historical and cross-sectional returns data to identify factors that explain returns and use an asset’s sensitivity to those factors to project future returns.
Describe the role of the Markowitz efficient frontier when a risk-free asset is added to a portfolio of risky assets.
Any portfolio that combines a risky asset portfolio that lies on the Markowitz efficient frontier and the risk-free asset has a risk-return trade-off that is linear (CAL is represented by a straight line).
The point at which a line drawn from the risk-free rate is tangent to the Markowitz efficient frontier defines the optimal risky asset portfolio. This line is known as the optimal CAL.
Describe the security characteristic line (SCL), and give its equation.
It plots the excess returns of a security against the excess returns of the market.
Ri − Rf = αi + βi(Rm − Rf)
Explain the macroeconomic factor model.
Macroeconomic factor models use economic factors (e.g., economic growth rates, interest rates, and inflation rates) that correlate with security returns to estimate returns.
Give the formula used to calculate the market model.
Ri=αi+βiRm+ei
Why do the SML and the CAPM apply to any security or portfolio, regardless of whether it is efficient?
Because they are based only on a security’s systematic risk, not total risk.
Mathematically express the capital asset pricing model (CAPM).
E(Ri)=Rf+βi[E(Rm)−Rf]
What is the Sharpe ratio used to compute?
Excess returns per unit of total risk
Explain fundamental factor models.
Fundamental factor models use relationships between security returns and underlying fundamentals (e.g., earnings, earnings growth, and cash flow growth) to estimate returns.
Describe the expected return, standard deviation, and correlation of a risk-free asset.
A risk-free asset has an expected return of the risk-free rate (RFR), a standard deviation (risk) of zero, and a correlation with any risky asset of zero.
List the assumptions of the CAPM.
Investors are utility-maximizing, risk-averse, rational individuals.
Markets are frictionless, and there are no transaction costs and taxes.
All investors have the same single-period investment horizon.
Investors have homogenous expectations and therefore arrive at the same valuation for any given asset.
All investments are infinitely divisible.
Investors are price-takers. No investor is large enough to influence security prices.
Describe the security market line (SML).
The SML illustrates the CAPM equation. Its y-intercept equals the risk-free rate, and its slope equals the market risk premium, (Rm − Rf).
