Week 4 Flashcards
What is the Sharpe ratio given by?
(The expected return of the portfolio - the risk free rate)/the standard deviation of the portfolio
Where do we find the optimal risky portfolio?
The point on the Markowitz frontier where the Sharpe ratio is the same as the capital allocation line is the optimal risky portfolio.
The slope of the capital allocation line is the Sharpe ratio.
What is the efficient frontier?
The efficient frontier is the set of portfolios that maximize the expected return at each level of portfolio risk. Everything on the Sharpe ratio curve above the minimum variance portfolio is on the efficient frontier of risky assets.
We should not want to invest in anything not on this efficient frontier, as we could always get the same level of returns with less risk by puying a mix of the efficient frontier portfolio and the risk free asset.
What are the Market assumptions of the Capital asset pricing model?
Market assumptions:
- All investors are price takes (accept the price as is)
- All information relevant to security analysis is free and publicly available
- All securities are publicly owned and traded
- No taxes on investment returns
- No transaction costs
- Lending and borrowing at the same risk-free rate are unlimited.
What are the Investor assumptions for CAPM?
Investor assumptions:
Investors plan for the same horizon, have the same expectations, are rational, and are mean variance optimizers.
What are the equilibrium conditions for CAPM?
- All investors hold the same portfolio of risky assets (which holds all securities).
- The market portfolio contains all securities.
- Risk premium on the market will depend on the average risk aversion of all market participants.
- The risk premium on individual assets will be proportional to the market risk premium and to the beta of the security in the market portfolio.
What is a capital market line?
It is like a capital allocaiton line but done using the market expected return and market standard deviation.
What is the security market line? What does it mean for an individual security’s under or overpricedness?
The security market line graphs the expected CAPM return against the systematic risk (Beta).
If a security is on this line it is correctly priced, if not on the line it will have an alpha value given by actual return - expected return. If this is positive the stock is underpriced, if it is negative the stock is overpriced.
What will the variance of a stock be according to CAPM?
relation to the market^2*market variance + any firm specific risk (0 for CAPM).
How do we get the beta of a portfolio?
Sum of each stock’s weights * the associated beta.
What is the beta of the risk free asset?
0.
What is the regression model for CAPM and excess returns?
excess returns = intercept(mispricing) + beta*return of market index + error.
If the intercept is larger or less than 0 and the t statistic is greater than or less than 1.64 then it is significant at 10%, allowing us to make a proper claim as to whether or not a stock is mispriced.
Is CAPM still useful if the assumptions are not valid? What are some useful takeaways?
Yes, the markets can still be “efficient” even without all assumptions being valid, and the principles are still useful like: investors should diversify, systematic risk matters, and a well diversified risky portfolio can be suitable for a wide range of investors
