Week 7 - Capital Asset Pricing Model Flashcards
Define systematic risk
Systematic risks are risks which impact on all firms e.g. national recession
Define unsystematic risk
Risks which are specific to a firm or sector
What is the trade off (most of the time) between the risk of an investment and the potential return
• Investments of high risk are likely to provide a higher potential return as opposed to a low risk investment
Characteristics of a well diversified portfolio
A group of investments which are negatively correlated within different sectors acting independently to each other
Examples of systematic risk
Examples of unsystematic risk
What is the use for a capital asset pricing model?
It is a way the return for an investment can be worked out, if we are a well diversified investor and we have eliminated unsystematic risk
What are the core principles of the capital asset pricing model (CAPM) (4)
• Every investment (share) has a risk where some investments are higher risk others are low risk
• Risk is measured using beta (β)
• The risk is measured relative to the average risk of the entire market. The market risk is given a value of 1.0
• β has a value in the range from 0 (no risk, theoretically impossible) through to a value much greater than 1.0
Formula for β
β = Covariance between the market and the stock/variance of the market
Interpretations of β value (Different types of investments based the value of β) (3)
• β greater than 1.0 is viewed as an aggressive investment
• β less than 1.0 is viewed a defensive investment
• β that’s approximately 1.0 is viewed as a neutral investment
Define risk free rate (rf)
Is the return expected from an investment which has no risk
Define market rate of return (rm)
Is the return expected from the market as a whole
Define the market securities line
Is a straight line which expresses the relationship between the return expected from an investment and the risk (beta)
Capital Asset Pricing Model (CAPM) graph
Formula the required return on equity (Ke)
risk free rate + (β x equity risk premium)
How can we use α to determine if an investment is worthwhile?
• Compare the value of the expected return to the required return.
• If the required return is lower than the exalted return the investment is worthwhile and the share price is undervalued
What is the formula for α
Initial expected investment based on dividend yield (expected return) - market required return
What is the impact of α being positive? (3)
• Expected return > required return resulting in excess demand for the investment at the current price
• Price will rise and expected return will fall until expected return = required return
• Share price will change in accordance with the percentage difference between the expected return and required return
Capital Asset Pricing Model (CAPM) Assumptions (5)
• Unsystematic risk can be eliminated for a well diversified investor
• The market is efficient and competitive… equalising supply and demand by changes in price
• There are no transactions costs
• A risk free investment exists in theory
• All investors have the same information
Formula for the share price after trading
Required market return/expected return x original share price
Define beta β (2)
• Beta β is a measure of the volatility, or systematic risk of a security (e.g. share) in comparison to the market.
• The average for the market is 1.0
Critique the following CAPM Assumption: Unsystematic risk can be eliminated for a well-diversified investor (2)
• Unsystematic risk does not eliminate systematic risks such as market crashes, economic recessions or geopolitical events
• Real world constraints such as investment costs, and imperfect correlations between assets, may prevent complete risk elimination
Critique the following CAPM Assumption: The market is efficient and competitive, equalising supply and demand by changes in price
This assumes that all available information is reflected in stock prices however market inefficiencies such as momentum effects, anomalies and behavioural biases exist which can lead to mispricing and arbitrage
Critique the following CAPM Assumption: There are no transaction costs
In reality investors face various costs, including brokerage fees, bid-ask spreads and taxes which impact investment decisions and returns - Ignoring these costs oversimplifies financial markets and can lead to in accurate pricing predictions under CAPM
Critique the following CAPM Assumption: A risk-free investment exists in theory (2)
• Despite government bonds are considered risk-free they still carry risks such as inflation, interest rate fluctuations and in some cases severing default
• Currency risks in international markets further challenge the notion of a truly risk-free asset
Critique the following CAPM Assumption: all investors have the same information
In reality investors have different levels of access to information due to asymmetric information, insider trading and varying analytical skills
What is the security market line?
The security market line (SML) defines the linear relationship between risk and return
Formula for Security (investment) market line (SML/rate of return of an investment )
What are the benefits of using CAPM? (2) (3)
• Investors only consider systematic risk to be relevant as diversification cancels out the risk which simplifies the analysis compared to if unsystematic risk was also considered
• Shares with higher levels of unsystematic risks are expected to yield higher rates of return helping to decide pricing and decision making
• Linear relationship between systematic risk and return and correctly priced should plot on the security market line making it easier for investors to make investment decisions
Interpretations of a security market line (SML)
• Fairly priced investments are on the SML
• Overpriced investment are below the SML
• Underpriced ones are above the SML
