The capital market line CAPM and single index model Flashcards
what properties does a risk free asset have?
- variance of zero
- zero covariance with other risk assets (no correlation)
- zero covariance with the market portfolio
what are the CAPM 6 assumptions?
- investors rely on expected return and variance in their decision making.
- all investors are rational and risk averse. subscribe to same methods of portfolio diversification as in standard portfolio theory.
- invest for same period.
- share all expectations about assets.
- risk free assets and investors can lend/borrow unlimited amounts at the risk-free rat, Rf.
- capital markets are perfectly competitive and frictionless.
What is CAPM equilibrium?
- investors agree in their forecasts of expected return, standard deviation and correlations.
- investors optimally hold risky assets in the same relative proportions.
- investors in general behave optimally. therefore prices of securities/assets adjust so that investors are holding their optimal portfolios. Demand = supply.
- CAPM is also known as the Security Market line (SML).
what is the security market line?
- SML is an equilibrium asset pricing model.
- not necessarily correct when looking at data.
- If assets lie above the SML they are undervalued and should be bought (good deal)
- if assets lie above the SML they are overvalued and should be sold.
Why do prices adjust quickly?
This is because of perfect information. People catch on and copy each other who buy / sell stocks so therefore prices adjust.
prices go down as more people sell the stock (due to knowing its overvalued) and supply increases. If supply increases the stock price is pushed down.
What is the market portfolio?
in theory, consists of a proportion of all potential assets in the world weighted in proportion to their retrospective market values
a well-diversified portfolio will have a risk proportional to the beta of the portfolio which is the average beta of the stocks included in the portfolio.
