setting up the CAPM Flashcards
CAPM
pricing model framework used to come up with the appropriate risk adjusted discount rate
statistical characteristics of asset returns
vaguely normally distributed
lessons from capital market history
- bearing risk is rewarded, return is only higher with higher risk
risk premium
the extra return from taking on risk, difference between returns on financial security and risk free
measuring returns
actual return equals relative price change plus any interim payments (dividends) the assets may give rise to
return next period
random variable models teh expected return
expected value
probability weighted average of outcomes
variance
fluctuation of a variable around its mean
standard deviation
square root of variance, also known as volatility/risk
covariance
The degree to which two random variables move in the same direction at the same time
correlation
another measurement of co- movements but normalised by standard deviations - always between + AND - 1.
portfolio
collection of assets
weight of an asset xi
must sum up to 1 but can be negative if buying/borrowing
expected return and variance on a portfolio
weighted averages of assets that constitute a portfolio
risk free assets are characterised by:
expected value = 0, variance = 0, covariance = 0
risk premium
initial risk - final risk
Sharpe ratio used to construct capital allocation line
return premium per unit of risk - want to be high as possible
what point on CAL is best
top of linear portion - higher risk higher reward. CAL represents what investors can get, return on y axis, volatility on y
indifference curves
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.
properties of indifference curves
- slope upwards
- convex
- cannot intersect
- increase in value as move to upper left hand corner
utility function
measures satisfaction, coefficient of utility measures risk aversion, if A = 0, risk neutral investor, if A < 0, risk loving investor (e.g. gambler)
standard deviation of a portfolio
equal to the weighted average of the standard deviations of assets in it ONLY if the assets are perfectly correlated
diversification benefits
same return for less risk more shorting opportunity
minimum variance portfolios
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/
equally weighted portfolios of independent assets
risk decreases with number of assets
sd declines with number of assets
excess return
a random variable of how much the return beats the risk free rates
investment opportunity set
a set of possible risk reward combinations of assetst
efficient portfolio
an asset with the highest reward for a given risk
efficient frontier
the set of all efficient portfolios
minimum variance portfolios
portfolio consisting only on risky assets with the lowest possible variance
systematic risk market wide undiversiable risk
risk due to pandemics geopolitics climate etc
diversifiable, idiosyncratic or firm (asset) specific risk
risk that can be eliminated by carefully combining assets in a portfolio
