week 8 Flashcards
what is the summary formula for CAPM
Rj = Rf +B (Rm - Rf)
Rj = expected return Rf = risk free rate Rm - Rf = average risk for a share Rm= market return B = measure of risk
what are the compensation for investing
inflation, impaitence and risk
how do calculate the required return of a company
Rj = Rf +RP
RP= risk premium
what is a risk premium
this is compensation for how risky a stock is, so if the stock is know to be poor the risk premium is likely higher
how big is the risk preimium? (how is calculated with words) no formula
estimate the risk premium for the averagely risky share on the market (Rm-Rf)
multiply this number by a risk adjustment factor (beta)
what happens if the risk premium is too small?
they would sell the shares
what is a bold assumption about risk premium
extra returns recieved in the past reflect their required returns
what are the objections of risk premium assumption (3)
- investors in shares in past decades might have been luck
- we also dont know how many years to look at β> we should look 50 years
- debate on whether to use the rate of retun on government bonds or the risk-free rate treasury bills
bills: truly risk free assets, but not good for the long term
bonds: premium for inflation risk. bad for the short term (defo will not default however)
looking at historical data how could you calcualte the risk premium
to find out the risk premium you must look into the long horizon.
you assume 1 asset as a risk-free
asst-rf-asset= gives tou the risk premium
what does data from Dimson show what the risk premium would be
data show that the risk premium would be 3-5 percent
since equities are 6 percent and the other assers are around 1-3 percent
what is the market protfolio? according to the diagram
this the point which intersects the efficient frontier
what is the expected return formula
πΈ(π π )=πΈ(π πΉ )+ππ (πΈ(π π )βπ πΉ )
what is the standard deviation portfolio formula
sqrt(ππΉ^2 *ππΉ^2 + ππ^2 *ππ^2 +2ππΉ *ππ * πππ£(π πΉ,π π))
What is the formula for the capital market line
E(Rf) = E (Rf) + πp/πm ((E(Rm) - Rf)
what is the formula formula for the market pice of risk
how much extra return you get if increase risk by 1 unit
((E(Rm) - Rf)/ πp
what is systemic risk
sk inherent to the entire market or market segment. Systematic risk, also known as βundiversifiable riskββ
what is unsystemic risk?
unique risk β> firms may make silly decisions such as a poor product
this is diverisifiable risk
what is beta
beta measures hte covarience between the returns ona share with the returns on the market as a whole
B = cov(Rj, Rm)/π^2M
what happens when B equals 1, less than zero and more than 0
Ξ² = 1 β A 1 per cent change in the market indexreturn generally leads to a 1 per cent change in the return on a specific share.
0 < Ξ² < 1 β A 1 per cent change in the market index return generally leads to a less than 1 per cent change in the returns on a specific share.
Ξ² > 1 β A 1 per cent change in market index return generally leads to a greater return than 1 per cent on a specific companyβs share.
whats the differnece between the security market line and the capital market line
The CML is sometimes confused with the security market line (SML). The SML is derived from the CML. While the CML shows the rates of return for a specific portfolio, the SML represents the marketβs risk and return at a given time, and shows the expected returns of individual assets. And while the measure of risk in the CML is the standard deviation of returns (total risk), the risk measure in the SML is systematic risk, or beta. Securities that are fairly priced will plot on the CML and the SML. Securities that plot above the CML or the SML are generating returns that are too high for the given risk and are underpriced. Securities that plot below CML or the SML are generating returns that are too low for the given risk and are overpriced.
what is the formila for the security market line
Rj = RF + Ξ²(RM β RF )
what causes shifts in the SML
changes in the risk free rate
- RF is in the long run average (in the formula)
what is the formula for the characteristic line
Rj = Ξ± + Ξ²j Γ RM + e Rj = rate of return on the jth share;
RM = rate of return on the market index portfolio; Ξ± = regression line intercept;
e = residual error about the regression line (in this simple case this has a value of zero because all the plot points are on a straight line);
Ξ²j = the beta of security j
what are the applications of CAPM
portfolio selection
mispriced shares
measureing portfolio peformance
calculating the required rate on a firms investment projects
accepted aspects of
Shareholders demand a higher return for riskier assets
Risk-averters are wise to diversify
The risk of securities (for example shares) has two elements: (a) unsystematic risk factors specific to firms which can be diversified away; and (b) systematic risk caused by risk factors common to all firms
Investors will not be rewarded for bearing unsystematic risk
Different shares have different degrees of sensitivity to the systematic risk elements
WHAT are the contraversial aspects of CAPM
Systematic risk is measured by beta which, in practice, iscalculated as the degree of co-movement of a securityβs return with a market index return
Beta, as calculated by examining past returns, is valid for decision making concerned about the future
what are the techonological problems of CAPM
not clear it is more appropiate to use dialy or uearly
supported historical beta β> they vary over time
Ex ante theory with ex post testing
The market portfolio is unobtainable
One-period model
Very few government securities are close to being risk free
Unrealistic assumptions
Investors are rational utility maximizers
Information is freely available
Investors can borrow and lend at the risk free-rate
Capital markets are perfectly competitive and frictionless
securities are infinitely divisible
