Risk return CAPM

Question 1

What is risk?

Answer 1

It is the variability in return. It measures the spread in return.

Question 2

What is covariance/correlation

Answer 2

The relationship between returns of two securities

Question 3

Why is systematic risk different to unsystematic risk?

Answer 3

• Systematic is firm specific, can be diversified away

- Under CAPM investors are well diversified so main risk is market risk

Question 4

What does CAPM do and what is the appropriate risk measure?

Answer 4

CAPM describes the relationship between a stock’s expected return and it’s risk. Beta is the appropriate risk measure under CAPM, as investors are assumed to be well diversified, so unsystematic (non-beta) risk is neutralised.

Question 5

What are the assumptions of CAPM?

Answer 5

• Investors are well diversified
• Perfect capital markets
• Single period transaction horizon

Question 6

What are the perfect capital market assumptions?

Answer 6

• No individual dominates the market
• Investors are rational and risk averse
• Investors have perfect information
• All investors can borrow or lend at risk free rate
• No transaction or period costs

Question 7

What are the limitations of the CAPM model?

Answer 7

• Unrealistic assumptions (Investors not well diversified, PCM assumptions unrealistic)
• Single period model unrealistic as most investment has long time horizon
• Beta calculated using historical data not future consideration
• “The market” difficult to define so need to use FTSE etc as proxy