CAPM

Question 1

What is CAPM?

Answer 1

The Capital Asset Pricing Model allows investors to determine the required rate of return for risky assets.

Question 2

Main Assumptions

Answer 2

• Informationally efficient market
• The market consists of several small investors
• Each investor has the same information and expectations with respect to risky assets
• Investors can borrow any amount of money at the risk-free rate of return
• All the investors are Markowitz efficient investors
• All investors have the same one-period time horizon
• There are no transaction costs involved when trading assets
• Capital markets are in equilibrium

Question 3

What is a risk-free asset?

Answer 3

The standard deviation of the risk-free asset is zero in theory. It has a correlation with any other risky asset.

Question 4

Covariance with risk-free asset

Answer 4

formula

Question 5

Combining a risk-free asset with a risky portfolio

Answer 5

Expected return and variance formulas

Question 6

What is the risk-return combination?

Answer 6

There is a linear combination on both the expected rerun and the standard deviation of returns.

Question 7

How is risk split in CAPM?

Answer 7

• Diversifiable or unsystematic risk
• Non-diversifiable or systematic risk

(if risk could be diversified away cheaply and easily then there should be no reward for taking it on)

Question 8

What does Beta measure?

Answer 8

Beta is used to measure risk relative to a well diversified portfolio.
Because even if you have a well diversified portfolio, there is a risk you could not diversify away because certain risks affect everything.

Question 9

Beta Formula

Answer 9

Covariance of asset and benchmark portfolio divided by the variance of the benchmark portfolio.

Question 10

Benefit of Beta

Answer 10

Beta enables us to estimate the undiversifiable risk of an asset and compare it with the undiversifiable risk of a well diversified portfolio.

Question 11

What is Beta?

Answer 11

Beta is a measure of volatility computed by using only historical data. It is a measure of risk an investor is exposed to by holding a particular stock or portfolio as compared to the market as a whole.
Beta is usually positive.

Question 12

Determining the expected rate of return for a risky asset

Answer 12

• The difference between the estimated and expected return is referred to as a stock’s alpha.
• Alpha can either be positive (undervalued) or negative (overvalued). If alpha is or close to zero, then the stock lies on the security market line and hence it is properly valued in line with systematic risk.

Question 13

SML- Security Market Line

Answer 13

• In equilibrium, all assets and portfolios should lie on the SML.
• Any stock with an estimated return that plots above the SML is underpriced.
• Any stock with an estimated return that plots below the SML is overpriced.

Question 14

Limitations of CAPM

Answer 14

• Stability of Beta
• The choice of market proxy
• Data used to approximate the beta and other components are based on historical observations
• Since the CAPM is a model based on expectations, the variables may (or may not) reflect the future variability of returns

Question 15

The stability of beta

Answer 15

The larger the number of stocks in the portfolio and the longer the period, the more stable.

Question 16

The market portfolio

Answer 16

The estimated required return will be biased if the market portfolio has not been chosen appropriately.

Question 17

Does only Beta affects returns?

Answer 17

No- firm size, book-to-market, and past return patterns can also affect stock returns.