setting up the CAPM

Question 1

CAPM

Answer 1

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

Question 2

statistical characteristics of asset returns

Answer 2

vaguely normally distributed

Question 3

lessons from capital market history

Answer 3

• bearing risk is rewarded, return is only higher with higher risk

Question 4

risk premium

Answer 4

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

Question 5

measuring returns

Answer 5

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

Question 6

return next period

Answer 6

random variable models teh expected return

Question 7

expected value

Answer 7

probability weighted average of outcomes

Question 8

variance

Answer 8

fluctuation of a variable around its mean

Question 9

standard deviation

Answer 9

square root of variance, also known as volatility/risk

Question 10

covariance

Answer 10

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

Question 11

correlation

Answer 11

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

Question 12

portfolio

Answer 12

collection of assets

Question 13

weight of an asset xi

Answer 13

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

Question 14

expected return and variance on a portfolio

Answer 14

weighted averages of assets that constitute a portfolio

Question 15

risk free assets are characterised by:

Answer 15

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

Question 16

risk premium

Answer 16

initial risk - final risk

Question 17

Sharpe ratio used to construct capital allocation line

Answer 17

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

Question 18

what point on CAL is best

Answer 18

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

Question 19

indifference curves

Answer 19

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.

Question 20

properties of indifference curves

Answer 20

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

Question 21

utility function

Answer 21

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

Question 22

standard deviation of a portfolio

Answer 22

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

Question 23

diversification benefits

Answer 23

same return for less risk more shorting opportunity

Question 24

minimum variance portfolios

Answer 24

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/

Question 25

equally weighted portfolios of independent assets

Answer 25

risk decreases with number of assets
sd declines with number of assets

Question 26

excess return

Answer 26

a random variable of how much the return beats the risk free rates

Question 27

investment opportunity set

Answer 27

a set of possible risk reward combinations of assetst

Question 28

efficient portfolio

Answer 28

an asset with the highest reward for a given risk

Question 29

efficient frontier

Answer 29

the set of all efficient portfolios

Question 30

minimum variance portfolios

Answer 30

portfolio consisting only on risky assets with the lowest possible variance

Question 31

systematic risk market wide undiversiable risk

Answer 31

risk due to pandemics geopolitics climate etc

Question 32

diversifiable, idiosyncratic or firm (asset) specific risk

Answer 32

risk that can be eliminated by carefully combining assets in a portfolio