setting up the CAPM Flashcards

1
Q

CAPM

A

pricing model framework used to come up with the appropriate risk adjusted discount rate

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2
Q

statistical characteristics of asset returns

A

vaguely normally distributed

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3
Q

lessons from capital market history

A
  • bearing risk is rewarded, return is only higher with higher risk
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4
Q

risk premium

A

the extra return from taking on risk, difference between returns on financial security and risk free

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5
Q

measuring returns

A

actual return equals relative price change plus any interim payments (dividends) the assets may give rise to

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6
Q

return next period

A

random variable models teh expected return

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7
Q

expected value

A

probability weighted average of outcomes

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8
Q

variance

A

fluctuation of a variable around its mean

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9
Q

standard deviation

A

square root of variance, also known as volatility/risk

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10
Q

covariance

A

The degree to which two random variables move in the same direction at the same time

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11
Q

correlation

A

another measurement of co- movements but normalised by standard deviations - always between + AND - 1.

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12
Q

portfolio

A

collection of assets

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13
Q

weight of an asset xi

A

must sum up to 1 but can be negative if buying/borrowing

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14
Q

expected return and variance on a portfolio

A

weighted averages of assets that constitute a portfolio

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15
Q

risk free assets are characterised by:

A

expected value = 0, variance = 0, covariance = 0

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16
Q

risk premium

A

initial risk - final risk

17
Q

Sharpe ratio used to construct capital allocation line

A

return premium per unit of risk - want to be high as possible

18
Q

what point on CAL is best

A

top of linear portion - higher risk higher reward. CAL represents what investors can get, return on y axis, volatility on y

19
Q

indifference curves

A

each curve is a set of portfolios/securities that keeps investor equally satisfied, high return preferred low risk is preferred. Represent what investors want. return on y, risk on x.

20
Q

properties of indifference curves

A
  • slope upwards
  • convex
  • cannot intersect
  • increase in value as move to upper left hand corner
21
Q

utility function

A

measures satisfaction, coefficient of utility measures risk aversion, if A = 0, risk neutral investor, if A < 0, risk loving investor (e.g. gambler)

22
Q

standard deviation of a portfolio

A

equal to the weighted average of the standard deviations of assets in it ONLY if the assets are perfectly correlated

23
Q

diversification benefits

A

same return for less risk more shorting opportunity

24
Q

minimum variance portfolios

A

if assets are only partially correlated correlation ( p< 1) portfolio standard deviation is less that weighted average of standard deviation of assets. THE LOWER THE CORRELATION COEEFFIEICENT TJE STRONGER THE DIVERSIFICATION - investors can obtain same level of expected return with lower risk.
minimum variance = 0 when p = -1/

25
equally weighted portfolios of independent assets
risk decreases with number of assets sd declines with number of assets
26
excess return
a random variable of how much the return beats the risk free rates
27
investment opportunity set
a set of possible risk reward combinations of assetst
28
efficient portfolio
an asset with the highest reward for a given risk
29
efficient frontier
the set of all efficient portfolios
30
minimum variance portfolios
portfolio consisting only on risky assets with the lowest possible variance
31
systematic risk market wide undiversiable risk
risk due to pandemics geopolitics climate etc
32
diversifiable, idiosyncratic or firm (asset) specific risk
risk that can be eliminated by carefully combining assets in a portfolio