TOPIC 6 - ASSET PRICING

Question 1

The Capital Asset Pricing Model (CAPM) describes the relationship between

Answer 1

systematic risk and expected return for assets, particularly stocks.

Question 2

Need asset pricing techniques in IPM bc

Answer 2

Need an approach to determine whether the individual securities are appropriately priced

Question 3

CAPM assumes investors are

Answer 3

1) single-period planners who agree on a common input list from security analysis
2) and seek mean-variance optimal portfolios
3) investors all use identifcal input lists (homogeneous expectations)

Question 4

CAPM assumes that security markets are ideal in the sense that

Answer 4

a. Relevant info about securities is widely and publicly available
b. There are no taxes or transaction costs
c. All risky assets are publicly traded
d. Investors can borrow and lend any amount at a fixed risk-free rate

Question 5

homogeneous expectations consistent with idea that

Answer 5

all relevant info is publicly available

Question 6

CAPM makes assumptions regarding

Answer 6

(1) individual behaviour

(2) market structure

Question 7

CAPM holds that in an equilibrium the market portfolio is the

Answer 7

unique mean-variance efficient tangency portfolio. Thus, a passive strategy is efficient.

Question 8

The CAPM market portfolio is a value weighted portfolio in teh sense that

Answer 8

each security is held in a proportion = to its market value divided by the total market value of all securities.

Question 9

If the market portfolio is efficient and the average investor neither borrows nor lends, then the risk premium

Answer 9

on the market portfolio is proportional to its variance, as well as the average coefficient of risk aversion across investors

Question 10

The CAPM implies that the risk premium on any individual asset or portfolio is the product of the

Answer 10

risk premium on the market portfolio and the beta coefficient

Question 11

beta coefficient is the

Answer 11

covariance of the asset return with that of the market portfolio as a fraction of the variance of the return on the market portfolio

B = Cov(r_i, r_m)/Var(r_m)

Question 12

When risk-free borrowing is restricted but all other CAPM assumptions hold, then the simple version of the CAPM is replaced by

Answer 12

its zero beta version. Accordingly, the risk-free rate in the expected return-beta relationship is replaced by the zero-beta portfolio’s expected rate of return

Question 13

The security market line of the CAPM must be modified to account for

Answer 13

labor income and other significant non-traded assets

Question 14

The consumption-based CAPM is a

Answer 14

single-factor model in which the market portfolio excess return is replaced by that of a consumption-tracking portfolio.

Question 15

By appealing directly to consumption, the consumption-based CAPM naturally incorporates

Answer 15

consumption-hedging considerations and changing investment opportunities within a single-factor framework

Question 16

Liquidity costs and liquidity risk can be

Answer 16

incorporated into the CAPM relationship. Investors demand compensation for expected costs of illiquidity as well as the risk surrounding these costs.

Question 17

the Capital Market Line replaces

Answer 17

the optimal risky portfolio P with the market portfolio M as the optimal risky asset

Question 18

where does the CML result from?

Answer 18

Taken by assumptions from CAPM that the market portfolio is the optimal risky asset and lies on the efficient frontier tangential to rf asset

Question 19

in regards to the market risk premium, what does the CAPM assume?

Answer 19

The market risk premium is proportional to its risk and the degree of risk aversion (E(R_m)=A*Variance_m

where A = investor’s risk aversion

Question 20

CAPM is built on the insight that the appropriate risk premium on an asset will be determined by

Answer 20

its contribution to the risk of investors’ overall portfolios

o All investors use the same input list, i.e., the same estimates of expected returns, variances and covariances
o Therefore, they all end up using the market as their optimal risky portfolio

Question 21

Index model states the realised excess return on any stock is the sum of the following:

Answer 21

o Realised excess return due to market-wide factors
o A nonmarket premium
o Firm-specific outcomes

Question 22

The index model beta coefficient is the same as the

Answer 22

beta of the CAPM expected return-beta relationship

Question 23

1) Identical Input Lists (Extension of CAPM)

Answer 23

a. In the absence of private information, investors should assume alpha values are zero

Question 24

2) Zero-Beta Model (Extension of CAPM)

Answer 24

a. Helps to explain positive alphas on low beta stocks and negative alphas on high beta stocks

Question 25

4) Multiperiod Model and Hedge Portfolios (Extension of CAPM)

Answer 25

a. Investors should be more concerned with the stream of consumption that wealth can buy for them not purely with the payoff/returns on financial assets over one period ahead

Question 26

5) Consumption-Based CAPM (CCAPM) (Extension of CAPM)

Answer 26

i. Investors allocate wealth between consumption today and investment for the future
ii. What’s relevant is that covariance of asset returns have with consumption growth  prediction of consumption based CAPM is that risk premiums are higher for assets with higher covariance with consumption growth  higher when assets payoff higher returns at the same time consumption is high

Question 27

6) Liquidity (Extension of CAPM)

Answer 27

a. Financial costs inhibit trades
b. Liquidity of an asset is the ease and speed with which it can be sold at fair market value
c. Illiquidity can be measured in part by the discount from fair market value a seller must accept if the asset is to be sold quickly

Question 28

Beta is the sensitivity

of the stock’s return to the

Answer 28

market return, i.e., the change in the stock return per unit

change in the market return.

Question 29

We compute each stock’s beta by calculating

Answer 29

the difference in its return across the two scenarios divided by the difference in the
market return:

B = (S1-S0)/(M1-M0)

Question 30

alpha αA =

Answer 30

Expected return – required return (given risk) as from the CAPM/SML

α<0 =overpriced (plots below the SML –> implies returns are too low relative to risk making it overpriced)

α > 0 = underpriced

Question 31

The hurdle rate is determined by

Answer 31

the project beta , not the firm’s beta (you’d then use the CAPM to figure out the return)

Question 32

total stock return formula

Answer 32

r = [(P1-P0)+D]/P0

if you’ve been given the E(r), can use this to work backwards to find the initial price etc

Question 33

PV perpetuity

Answer 33

= perpetual CF/r

or discount rate - g rate if given

Question 34

Murray wants to increase the expected return of his portfolio. State what action
McKay should take to achieve Murray’s objective. Justify your response in the
context of the CML.

Answer 34

McKay should borrow funds and invest those funds proportionately in Murray’s existing portfolio (i.e., buy more risky assets on margin). In addition to
increased E(r) the alternative portfolio on the capital market line will also have increased risk, which is caused by the higher proportion of risky assets in the total portfolio.

Question 35

York wants to reduce the risk exposure of her portfolio but does not want to engage in
borrowing or lending activities to do so. State what action McKay should take to
achieve York’s objective. Justify your response in the context of the SML.

Answer 35

McKay should substitute low-beta stocks for high-beta stocks in order to
reduce the overall beta of York’s portfolio.

By reducing the overall portfolio beta, McKay will reduce the systematic risk of the portfolio and, therefore, reduce its volatility relative to the market. The security market line (SML) suggests such action (i.e., moving down the SML), even though reducing beta may result in a slight loss of portfolio efficiency unless full diversification is maintained. York’s primary objective, however, is not to maintain efficiency but to reduce risk exposure; reducing
portfolio beta meets that objective. Because York does not want to engage in
borrowing or lending, McKay cannot reduce risk by selling equities and using the
proceeds to buy risk-free assets (i.e., lending part of the portfolio).