week 8

Question 1

what is the summary formula for CAPM

Answer 1

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

Question 2

what are the compensation for investing

Answer 2

inflation, impaitence and risk

Question 3

how do calculate the required return of a company

Answer 3

Rj = Rf +RP

RP= risk premium

Question 4

what is a risk premium

Answer 4

this is compensation for how risky a stock is, so if the stock is know to be poor the risk premium is likely higher

Question 5

how big is the risk preimium? (how is calculated with words) no formula

Answer 5

estimate the risk premium for the averagely risky share on the market (Rm-Rf)

multiply this number by a risk adjustment factor (beta)

Question 6

what happens if the risk premium is too small?

Answer 6

they would sell the shares

Question 7

what is a bold assumption about risk premium

Answer 7

extra returns recieved in the past reflect their required returns

Question 8

what are the objections of risk premium assumption (3)

Answer 8

• investors in shares in past decades might have been luck
• we also dont know how many years to look at –> 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)

Question 9

looking at historical data how could you calcualte the risk premium

Answer 9

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

Question 10

what does data from Dimson show what the risk premium would be

Answer 10

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

Question 11

what is the market protfolio? according to the diagram

Answer 11

this the point which intersects the efficient frontier

Question 12

what is the expected return formula

Answer 12

𝐸(𝑅𝑝 )=𝐸(𝑅𝐹 )+𝜔𝑀 (𝐸(𝑅𝑀 )−𝑅𝐹 )

Question 13

what is the standard deviation portfolio formula

Answer 13

sqrt(𝜔𝐹^2 *𝜎𝐹^2 + 𝜔𝑀^2 *𝜎𝑀^2 +2𝜔𝐹 *𝜔𝑃 * 𝑐𝑜𝑣(𝑅𝐹,𝑅𝑀))

Question 14

What is the formula for the capital market line

Answer 14

E(Rf) = E (Rf) + 𝜎p/𝜎m ((E(Rm) - Rf)

Question 15

what is the formula formula for the market pice of risk

Answer 15

how much extra return you get if increase risk by 1 unit

((E(Rm) - Rf)/ 𝜎p

Question 16

what is systemic risk

Answer 16

sk inherent to the entire market or market segment. Systematic risk, also known as “undiversifiable risk’’

Question 17

what is unsystemic risk?

Answer 17

unique risk –> firms may make silly decisions such as a poor product

this is diverisifiable risk

Question 18

what is beta

Answer 18

beta measures hte covarience between the returns ona share with the returns on the market as a whole

B = cov(Rj, Rm)/𝜎^2M

Question 19

what happens when B equals 1, less than zero and more than 0

Answer 19

β = 1 ⇒ 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 < β < 1 ⇒ 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.

β > 1 ⇒ A 1 per cent change in market index return generally leads to a greater return than 1 per cent on a specific company’s share.

Question 20

whats the differnece between the security market line and the capital market line

Answer 20

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 market’s 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.

Question 21

what is the formila for the security market line

Answer 21

Rj = RF + β(RM − RF )

Question 22

what causes shifts in the SML

Answer 22

changes in the risk free rate

• RF is in the long run average (in the formula)

Question 23

what is the formula for the characteristic line

Answer 23

Rj = α + βj × RM + e
Rj	= rate  of return on  the jth share; 

RM	= rate  of return on  the market  index portfolio;
α	= 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);

βj = the beta of security j

Question 24

what are the applications of CAPM

Answer 24

portfolio selection
mispriced shares
measureing portfolio peformance

calculating the required rate on a firms investment projects

Question 25

accepted aspects of

Answer 25

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

Question 26

WHAT are the contraversial aspects of CAPM

Answer 26

Systematic risk is measured by beta which, in practice, iscalculated as the degree of co-movement of a security’s return with a market index return

Beta, as calculated by examining past returns, is valid for decision making concerned about the future

Question 27

what are the techonological problems of CAPM

Answer 27

not clear it is more appropiate to use dialy or uearly

supported historical beta –> 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