Week 6 - CAPM (1) Flashcards
Who created the CAPM theory?
Markowitz, Sharpe, Lintner and Mossin are
researchers credited with its development
How do you calculate the required rate of return?
ri = rf + βi p x (E (Rp)-rf)
What does the required rate of return imply?
That E (Ri) > rf + βi p x (E (rp) -rf)
Thus expected return of investment i must be higher than required return in order to invest in
SEE EXAMPLE IN NOTES
What is process of a portfolio reaching to equilibrium?
If expected return is higher than the required return, we keep buying asset i. As we buy more, its correlation (and its beta) with our portfolio increases. ⇒ Increases the require return until we get the equality
Thus, if we face no restrictions in trading in the stock market, we will continue to trade until the expected return of each security equals its required return, that is, until E(Ri) = ri
holds for all i.
At this point, portfolio is the optimal, efficient portfolio.
What is the initial equiibrium calculation?
E(Ri) = ri = rf + βi eff x (E (r eff) -rf)
eff is efficient portfolio and is to the power of
What does the initial equilibrium condition imply?
That we can compute the expected return
of any security based on its beta with the efficient portfolio.
But for this we need to compute the efficiency portfolio which is difficult.
How does CAPM use optimal choices made by investors?
Uses them to identify the efficient portfolio as the market portfolio, the portfolio of all stocks and securities in the market.
What assumptions does CAPM rely on?
- Investors can buy and sell all securities at competitive market prices and can borrow and lend at the risk-free interest rate.
- Investors hold only efficient portfolios of traded securities, portfolios that yield the maximum expected return for a given level of volatility.
- Investors have homogeneous expectations regarding the volatilities, correlations, and expected returns of securities.
What are the implications of these assumptions?
- If investors have homogeneous expectations, they will all be holding the tangent portfolio (of risky securities).
- All investors demand the efficient portfolio, and the supply of securities is the market portfolio; hence the two must coincide.
What does CAPM essentially argue?
That since investors have the same expectations and buy portfolios at an efficient prices, the optimal/efficient portfolio matches the market portfolio
What happens if a security isn’t a part of the efficient portfolio?
Simply means not enough demand for that security -> So price decreases, meaning E(r) increases -> Thus investment more attractive and becomes efficient and part of the portfolio
How does the Capital Allocation Line become the Capital Market Line?
When the CAPM assumptions hold, the market portfolio is efficient, so the tangent portfolio is actually the market portfolio.
In this case the tangent line is called the capital market line (CML)
SEE GRAPH IN NOTES
Why can we now rewrite the CAPM equilibrium as a result of the assumptions and what does it become?
CAPM assumptions, we can identify the efficient
portfolio: It is equal to the market portfolio
E(Ri) = ri = rf + βi × (E(RMkt) − rf )
How do you calculate the Beta?
βi =SD(Ri) × Corr(Ri, RMkt)/ SD(RMkt)
= Cov (Ri, RMkt)/ Var(RMkt)
What does the BETA of the market represent?
Measures its volatility due to market risk relative to the market as a whole, and thus captures the security’s sensitivity to market risk
i.e. If mkt change by 1% what will the change in return of a stock be
SEE EXAMPLE IN NOTES
