T6

Question 1

capm

Answer 1

CAPM is an equilibrium model specifying a relation between expected rates of return and covariances for all assets. It answers two key questions:

What portfolios should investors hold in equilibrium?
What is the equilibrium required return, E(R), or equilibrium price of a stock ?

Question 2

capm setting

Answer 2

A capital market in which all investors independently optimize and achieve the Markowitz condition (mean-variance optimization) for their portfolios
There is zero net supply of risk-free asset (i.e. lending = borrowing)
Supply of securities is fixed (in the short run)

Question 3

capm assumptions

Answer 3

Perfectly competitive market
Investors are myopic. All investors are looking over the same (one period) holding period
Assets are all tradable and are all infinitely divisible
No taxes/commisions/transaction costs
Decisions are made solely in terms of expected returns and variances (mean variance optimizer)
Unlimited short sales and borrowing & lending at the risk free rates.
All investors have access to the same information.
Fully rational investors with homogeneous expectations. (i.e. everyone uses the same estimates of expected return and the same variance/covariance matrix.)

Question 4

market portfolio of capm

Answer 4

market portfolio is the MVE portfolio of risky assets
Tangency Portfolio (M)= MARKET PORTFOLIO

Question 5

lessons on capm

Answer 5

1) All investors will choose the same MVE portfolio, which is the market portfolio, Just in different proportions depending on their risk aversion
2) The market portfolio represents the average holdings across investors. In other words, the average investor holds the market.
3) The CAL for a single investor is now called CML because every investor has the same CAL.
4) The market portfolio has a risk premium, which is an increasing function of the “average investor’s risk aversion and the volatility of the market.

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Question 6

SML vs CML

Answer 6

In SML, risk is measured by beta. In CML, risk is measured by 𝜎
CML is applicable only to an investor’s final (combined) portfolio (which is efficiently diversified, with no unique risk). In the CAPM world, everybody holds portfolios which lie on the CML.

SML is applicable to any security, asset or portfolio (which may contain both components of risk). In a CAPM world every asset lies on the SML.

Question 7

applications of capm

Answer 7

Portfolio choice
Shows what a “fair” security return is:
We identify whether the security is overpriced or underpriced.
Gives benchmark for security analysis
Required return used in capital budgeting to compute NPV of risky project or “hurdle rate” for IRR
Evaluation of fund manager performance.

Question 8

Implications of the standard CAPM

Answer 8

Expected returns on all assets are linearly related to their betas, and only beta has marginal explanatory power for differences in returns among securities

2. In a market with risk-averse investors, the beta premium is positive
3. Assets uncorrelated with the market have expected returns equal to the risk- free interest rate and assets perfectly correlated with the market have expected return on the market.

Question 9

why capm perforce poorly

Answer 9

Imperfect measure of market portfolio (Roll’s critique
Betas are estimated with error
The CAPM should hold in single period, but may not hold for longer time
Data mining: For example, size premium seems to die out in recent years