the CAPM

Question 1

CAPM

Answer 1

equilibrium model that provides a precise prediction of what relationship should be observed between risk and return and thus the precise prediction of the current prices of assets

Question 2

cons of CAPM

Answer 2

makes assumptions
- posits one source of risk affecting expected return BUT makes it easier to apply,

Question 3

pros of CAPM

Answer 3

only asset pricing model that is easy to apply
defines a benchmark (fair expected return) against which compare observed average return.
can be applied publicly and privately
specified what cost of capital (applicable discount rate) should be in order to help make capital nudgeting decisions.

Question 4

measure of systematic risk

Answer 4

single risk factor employed by the CAPM

Question 5

capital market line

Answer 5

connects risk free asset with market portfolio risk averse investors hold more of the risk-free asset and risk tolerant investors hold more market portfolio

Question 6

CAPM assumptions

Answer 6

investors have homogenous expectations
no transaction costs and no taxes
all assets publicly traded and held

Question 7

deriving the CAPM

Answer 7

derive using variance - SEE NOTES but interpretation is that the total expected return of an asset added to an efficiently diversified portfolio = time balue of money which is the risk free rate and compensation for worrying which is a risk premium. CAPM SAYS THAT THE RISK PREIMIMUM = product of a benchmark risk premium and the relative risk of an asset is measured by its beta

Question 8

beta

Answer 8

the contribution of that asset to the risk of the overall risky portfolio - no bounds on beta - an asset w negative beta moves against the market and 0-1 will move only by a bit in market direction, much higher than 1 will be sensitive to market fluctuations. Market may move and this move will be amplified by the much larger movement in the asset in the same direction. = cov(rm, ri) / var (rm) MEASURE OF SYSTEMATIC RISK OF THE ASSET

Question 9

markets sensitivity to fluctuations

Answer 9

= 1

Question 10

negative beta

Answer 10

expected return below risk free rate e.g. . insurance industry, sector suffers when things go bad market wide or e.g. gold, negatively correlated with many other assets specifically stocks but after global fin crisis more wanted gold for safety or hedging hence lower returns on gold.

Question 11

capm and systematic risk

Answer 11

only risk that is priced and has a positive linear relationship, idiosyncratic risk can be and is diversified away so not priced

Question 12

security market line

Answer 12

expected return plotted as a function of beta, depicts the positive linear relationship between the expected return and the sensitivity of each asset to fluctuations in the returns of the market portfolio. Slope is the risk premium of the market portfolio, return of market portfolio is given when between = 1.

Question 13

CML vs SMAL

Answer 13

CML graphs risk premium s of efficient portfolios as a function of portfolio sd , SML measures individual asset risk premiums as a function of asset risk.

Question 14

alpha

Answer 14

difference between actual return and what capM states. The unexpected deviation from the fair return. the excess performacne above the CAPM can be negative.

Question 15

measuring investing skills (performance)

Answer 15

lowest beta, highest alpha

Question 16

capital budgeting

Answer 16

depends on Net present value. (= the present value of future cash inflows appropriately risk -adjusted discount rate), only undertake projects with NPV>0 or NPV = 0.

Question 17

NPV

Answer 17

= PV (inflow) - cash outflow today

Question 18

assessing project viability

Answer 18

NPV >= 0
IRR (internal rate of return = yield) > cost of capital
accept if IRR. E[RPR] which is the same as NPV>0