Week 8: Valuation under Uncertainty

Question 1

What are the two types of risk?

Answer 1

Systematic- Risks that is tied to the market and cannot be diversified away.

Unsystematic risks- Risks that are specific to a particular company or industry and can be diversified away.

Question 2

What is a market portfolio?

Answer 2

A valued weighted portfolio of ALL assets in the economy.

Question 3

What is beta?

Answer 3

A relative measure of systematic risk. (A measure of stock’s volatility in relation to the overall market).

Question 4

What is the formula of beta?

Answer 4

Covariance/ Variance

Question 5

What does it mean if the beta is high?

Answer 5

the stock is more sensitive to the market (more volatile).

Question 6

What is considered a high beta is what is considered low?

Answer 6

Above 1= High- more risky but higher return potential.

Below 1= Low- less risky but lower returns potential.

Question 7

What does a positive and negative beta mean?

Answer 7

Positive- Moves in the same direction as the market.

Negative- Moves in the opposite direction as the market.

Question 8

What are the 4 steps in calculating beta?

Answer 8

1) Gather data.
2) Calculate variance of returns on the market.
3) Calculate the covariance of the market and individual stock.
4) Calculate beta

Question 9

What are some of the assumption of CAPM?

Answer 9

1) Investors goal is to maximise returns

2) Investors are rational and risk averse.

3) Portfolios are well diversified.

4) Investment is treasury bills is risk-free.

Question 10

What risk should investors focus on?

Answer 10

Market risk (systematic) as you cannot change these.

Question 11

What risk does CAPM look at?

Answer 11

Systematic risk only.

Question 12

What is the security market line?

Answer 12

A line that graphically represents the CAPM.

The X-axis represent risk (beta) and Y axis expected return.

Question 13

Where should an investment aim to be (regarding SML)

Answer 13

One the SML line. Anything below has a risk too high for the expected level of return.

Question 14

What are the uses of CAPM ?

Answer 14

1) Finding appropriate discount rates.

2) Selecting appropriate investment.

3) Evaluating portfolio performance.

Question 15

How can you use Jensen’s measure to see if security is priced correctly?

Answer 15

If CAPM hold, alpha will be zero. It its above, security is underpriced, if it is below, security is overpriced.

Question 16

What happens to overpriced/ underpriced securities over time?

Answer 16

Those over the SML line (overvalued) investors will buy more, pushing the price back down to equlibrium ( SML) and visa versa.

Question 17

What does Jensen’s Alpha measure?

Answer 17

represents the average return on a portfolio or investment, above or below that predicted by the CAPM. The higher the value the better.

Question 18

What are the arguments for CAPM?

Answer 18

1) It is easy to use
2) Focuses on systematic risk unlike other models.

Question 19

What are the arguments against CAPM?

Answer 19

1) Assumptions are too unrealistic/ restrictive. (assumptions)
2) Beta may not be the best factor to use.
3) Results are only as good as the data used.

Question 20

What are the 2 alternative theories for CAPM?

Answer 20

1) Arbitrage Pricing Theory (APT)

2) Multi-factor Theory

Question 21

What is Arbritage Pricing Theory?

Answer 21

APT argues that beta alone cannot explain the returns of individual shares. Other factors are very important.

Question 22

What are the steps in estimating expected returns based on APT?

Answer 22

1) Identify short list of macroeconomic factors that can affects stock.

2) Estimate expected price based on each of the identified factors?

3) Measure the sensitivity of each stock to the market.

Question 23

What are some of the possible macroeconomic factors (APT)?

Answer 23

• Changes in interest rates
• Bankruptcy risk
• Oil prices
• Currency exchange rates
  etc

Question 24

What are the applications of ATP?

Answer 24

• Use as a discount rate
• Identify mispriced securities

Question 25

What are the similarities/ differences between CAPM and APT?

Answer 25

Similarities:
- Models to price the asset.
-APT is simply a multi-factor version of CAPM

Differences:
- Market portfolio is not considered in APT.
- APT is less restrictive in assumptions.
- Beta may be harder to calculate for APT

Question 26

What is the multi factor model?

Answer 26

CAPM only measure Beta, where as ATP measure loads of data- may be hard too short-list factors.
Therefore multi factor choses 3 factors to consider.

Question 27

Similarities and differences between CAPM and APT and multi-factor model?

Answer 27

Similarities:
- Both used to set prices of assets
- Both focus on systematic risk.
- Can be seen an an extention of CAPM.

Differences:
- Multi factors is easier to apply than APT.
- Multi-factor includes more than one beta, unlike CAPM.