Topic 5: Asset Pricing Models Flashcards
How is the CAPM derived and what does it show?
- Derived using principles of diversification with simplified assumptions
- Showing the relationship between risk and
expected return of an asset
What researchers are credited with its development?
Markowitz, Sharpe, Lintner and Mossin
What are the first 3 assumptions of the CAPM?
1) Individual investors are price takers
2) Single-period investment horizon (ignoring anything that might happen afterwards)
3) Investments are limited to traded financial assets (can borrow or lend at risk-free rate)
What are the last 4 assumptions of the CAPM?
4) No taxes and transaction costs
5) Investors are rational mean-variance optimizers
6) There are homogeneous expectations
7) Information is costless and available to all investors
What is the market portfolio?
- Market portfolio contains all securities and the proportion of each security is its market value as a percentage of total market value
What does CAPM assume about risk premiums?
- assumes that appropriate risk premium on an asset will be determined by its contribution to the risk of investors’ overall portfolios
The variance of the portfolio is …….?
- The sum of all elements
What does beta measure?
- Beta measures the stock’s contribution to the variance of the market portfolio
what does the CML graph?
- CML graphs the risk premiums of efficient portfolios as a function of portfolio standard deviation
What does the SML graph?
- SML graphs individual asset risk premiums as a function of asset risk; the measure of risk for individual assets held as parts of well-diversified portfolios is the contribution of the asset to the portfolio variance (beta)
How can CAPM be used to analyse securities?
- portfolio manager will increase the weights of securities with positive alphas and decrease the weights of securities with negative alphas
How is CAPM is useful in project or asset valuation?
- useful in asset or project valuation by providing required rate of return (NPV valuation; DDM valuation)
Is the condition of zero alphas for all stocks as implied by the CAPM met?
- Not perfect but one of the best available
is CAPM testable?
- Proxies must be used for the market portfolio
Is CAPM still considered one of the best available description of security pricing and is widely accepted
- Yes
Whats the difference between beta in CAPM and beta in single index model?
- They look the same, however, CAPM measures expected returns, while single index model measures real/historical returns
The CAPM states that the expected value of alpha
should be what for all securities?
- Zero
The index model
holds that the realized value of alpha should
average out to _____ for a sample of historical
observed returns
- Zero
What does ‘m’ stand for in the two different models?
- In single index model, “m” stands for a market
index - In CAPM, “m” stands for the whole market, which consists of all securities in the market
How can arbitrage arise?
- arises if an investor can construct a
zero investment portfolio with a sure profit- Since no investment is required, an investor can create large positions to secure large levels of profit
Unlike CAPM, what does APT not assume?
- Single-period investment horizon
- Absence of personal taxes
- Risk-free borrowing or lending
- Mean-variance decisions
Whats the most important thing with the APT model?
- the deviations of the factors from their expected values.
3 comparisons between APT and CAPM
- APT applies to well diversified portfolios and
not necessarily to individual stocks - APT is more general in that it gets to an
expected return and beta relationship without
the assumption of the market portfolio - APT can be extended to multifactor models
