Week 1 - CAPM overview

Question 1

5 CAPM assumptions (from FM212)

Answer 1

1. Investors can borrow/lend unlimited amounts at the SAME RISK-FREE rate
2. Asset markets are frictionless and info is COSTLESS & available to all investors -> no transaction costs or taxes
3. Investors are rational MEAN-VARIANCE OPTIMISERS (only care about mean & variance)
4. Investors have HOMOGENEOUS EXPECTATIONS about securities,
   ie. expected returns & the covariance matrix of security returns {& std dev}
   ^strong assumption
   -> hence all investors get the same efficient frontier, & all hit the same tangency portfolio since same risk-free rate & MV optimisers
5. All investors are risk-averse & have a ONE-PERIOD HORIZON.

Question 2

How do we determine whether the non-zero alpha estimates from the regressions reflect Sampling errors or Real mispricing?

[PS1]

Answer 2

To test the hypothesis of whether the intercepts (3% for A, and –2% for B) are SIGNIFICANTLY DIFFERENT from zero, we would need to compute t-VALUES for each
intercept.