CAPM

Question 1

When r(a) is the appropriate measure?

Answer 1

When decisions are being taken on a forward-looking basis:
• Represents the mean of all the returns that may possibly occur over the investment holding period
• Best estimator of expected (short-term) future return • • • • The best gauge of the expected risk premium

Question 2

When geometric mean r(g) is the appropriate measure?

Answer 2

Best measure of realized (past) returns on an investment

Question 3

Measure of risk?

Answer 3

Volatility is not a complete measure of risk– higher moments of returns

Question 4

What is Skewness?

Answer 4

A measure of symmetry, or more precisely, the lack of symmetry
• A distribution, or data set, is symmetric if it looks the same to the left and right of the center point
Negative values for the skewness indicate data that are skewed left - Reflects tail risk or crash risk
• Positive values for the skewness indicate data that are skewed right

Question 5

What is Kurtosis?

Answer 5

A measure of whether the data are peaked or flat relative to a normal distribution

Question 6

What is Leptokurtic Distribution?

Answer 6

-> (K > 3)
A distribution with wide tails and a tall narrow peak is called leptokurtic Compared with a normal distribution, a larger fraction of the returns are at the
extremes rather than slightly above or below the mean of the distribution

Question 7

What is Platykurtic Distribution?

Answer 7

-> K < 3
A distribution with thin tails and a relatively flat middle is called platykurtic Relative to a normal distribution, a larger fraction of the returns are clustered around the mean

Question 8

How do you know if there are any diversification benefits?

Answer 8

As long as asset returns are not perfectly correlated, the standard deviation (risk) of the portfolio is less than the weighted average of the assets standard deviations

Question 9

Main goal of diversification?

Answer 9

Diversification reduces variability of returns if returns are not perfectly correlated

Question 10

What is Diversification?

Answer 10

Strategy designed to reduce risk by spreading the portfolio across many investments.

Question 11

What is Unique Risk?

Answer 11

Risk factors affecting only that firm - Also called “diversifiable risk”

Question 12

What is Market Risk?

Answer 12

Economy-wide sources of risk that affect the
overall stock market
- Also called “systematic risk”
- Reason why stocks have a tendency to move together – common factor affecting all stocks

Question 13

What are Two Implications From Diversification?

Answer 13

1. Only systematic risk determines expected returns
   - Since the unique risk can be diversified away for free by forming portfolios, investors can rationally only demand compensation for the systematic (non-diversifiable) risk
   - Marginal systematic risk of an asset gauged by its β-value relative a well-diversified portfolio (not by the total risk)
2. Value Additivity
   - Investors that can diversify on their own account will not pay extra for firms that diversify

Question 14

Markowitz Portfolio Theory

Answer 14

Possible to build a portfolio theory from our previous insights
1. Form diversified portfolios that reduce the risk (standard deviation) since asset returns are not perfectly correlated
• Reduce standard deviation, below the level obtained from a simple weighted - average calculation
• Correlation coefficients make this possible
2. Derive the exact principles of how to construct well-diversified portfolios
3. Define and find the various weighted combinations of stocks that create the set of efficient portfolios

Question 15

What is an efficient portfolio frontier?

Answer 15

All portfolios that are not mean-variance dominated by another portfolio:

• Not possible to rank portfolios in this set by the mean- variance criterion
• Part of the portfolio frontier that starts from the minimum variance portfolio and move upwards as portfolio risk increases
• NOTE: We only consider risky assets

Question 16

Explain short selling

Answer 16

• Borrow a stock, sell it to cash in and then restore it to the original owner by buying it back later
• Possible to go short in order to gain on expectations that stock price will decline

Question 17

How stock prices are assumed to look?

Answer 17

Stock prices assumed to follow a lognormal distribution -> But since negative stock prices are impossible, it is incorrect to assume that they follow a normal distribution:
-> Characterized only by two moments
μ (expected value — mean) and σ (standard deviation)

Question 18

What is risk aversion?

Answer 18

The term risk-averse refers to investors who, when faced with two investments with a similar expected return, prefer the lower-risk option. Risk-averse can be contrasted with risk seeking.

Question 19

What happens when the correlation between two assets is -1?

Answer 19

Investor has the opportunity to create a perfectly hedged position. -> variance of the portfolio is 0

Question 20

Step to be taken in Mean-Variance Analysis?

Answer 20

1. Specification of a set of securities for consideration.
2. Analysis of the prospects of these securities. Expected returns, variances and covariances must be estimated for all the securities being considered.
3. The efficient set is determined. With the addition of risk-free asset, the efficient set becomes a straight line.
4. The fourth and final stage is to identify the investors optimal portfolio (personal preferences).

Question 21

What CAMP says?

Answer 21

The market portfolio is an efficient portfolio and hence the tangency portfolio

Question 22

What is the The Security Market Line?

Answer 22

A line that serves as a graphical representation of CAPM, which shows different levels of systematic (market) risk of various marketable securities against the expected return of the entire market at a given point in time.
The SML is a visual of the capital asset pricing model (CAPM), where the x-axis of the chart represents risk in terms of beta, and the y-axis of the chart represents expected return. The market risk premium of a given security is determined by where it is plotted on the chart in relation to the SML.

Question 23

Name CAPM Interpretation

Answer 23

The assets expected return is the sum of risk free and assets risk premium proportional to the market risk premium.

Question 24

Explain negative beta values

Answer 24

Something that generates return that is lower than the risk premium (insurance policy -> negative return in general)
Individual stocks cannot have negative returns (with an exception for a really short period of time)

Question 25

Robustness of CAPM

Answer 25

Modifying some of its assumptions leaves the general model unchanged. BUT: When several assumptions are modified simultaneously, the departure from the standard CAPM may be larger

Question 26

Normative Assumptions Behind CAPM

Answer 26

1. Investorsevaluateportfoliosbylookingatthe expected returns and standard deviations of the portfolios over one -period horizon 2. Investors are never satiated 3. Investors are risk - averse 4. Assets are infinitely divisible 5. Perfect competition 6. There is a risk free rate of interest at which an investor may either lend or borrow 7. Investments are limited to a universe of publicly traded financial assets 8. All investors have the same one - period horizon 9. The risk free rate is the same for all investors 10. Information is freely and instantaneously available to all investors 11. Investors have homogeneous beliefs

Question 27

Describe the relationship between M/B (Market to book) and returns

Answer 27

Strong negative relation between market-to-book equity and return regardless of what other explanatory variables were included in the regression -> the higher the B/M the greater the company value (markets have incorporated some intangible assets into the value)

Question 28

Explain beta strategy

Answer 28

invest in market portfolio or well diversified portfolio on the SML line -> passive investment

Question 29

Explain smart beta strategy

Answer 29

Invest in specific measure (ex. B/M) -> something between passive and active investment

Question 30

What is Arbitrage Pricing Theory?

Answer 30

Multi-factor asset pricing model based on the idea that an asset's returns can be predicted using the linear relationship between the asset’s expected return and a number of macroeconomic variables that capture systematic risk. Implementation 1. Identify the macroeconomic factors 2. Estimate the risk premium for each factor 3. Estimate the factor sensitivities

Question 31

Three APT Implications

Answer 31

1. An asset with zero exposure to all factors has a zero risk premium -> (A portfolio constructed to have zero sensitivity to all macro factors is de facto risk-free and should be priced to offer the risk-free rate of return) 2. A diversified portfolio constructed to have exposure to only one factor will have a risk premium that varies in direct proportion to the portfolio’s sensitivity to that factor 3. If the risk premium on each of the APT factors is proportional to the market risk premium (CAPM) then the APT and CAPM are identical

Question 32

Three components of the APT

Answer 32

 Factors move up and down with the economy, and affect the future cash flows of securities.  Factor loadings for each security, for each factor, tell you how much the security moves (on average, in percent) when the factor moves by 1%.  Factor risk-premiums for each factor, tell you how much higher a discount-rate investors apply to a security if its factor loading on a particular factor is higher by one

Question 33

What is The three factor model?

Answer 33

Two basic principles are common 1. Investors require extra expected return for taking on risk 2. Investors primarily concerned with the risk they cannot diversify away

Question 34

On what the position of a portfolio in a ranking based on rate of return depends on?

Answer 34

- Risk level of the portfolio - Performance of the market - Skill level of the portfolio manager

Question 35

Name three kinds of risk

Answer 35

1. portfolio total risk 2. portfolio market (systematic) risk 3. non-systematic risk

Question 36

Describe the Sharpe ratio

Answer 36

Is used to help investors understand the return of an investment compared to its risk. The ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. Appropriate if portfolio manager limited in his/her choice of assets e.g. due to restrictions on fund, i.e. limited in ability to diversify

Question 37

Describe the Modigliani & Modigliani Measure (aka Modigliani risk-adjusted performance)

Answer 37

Similar to Sharpe ratio -> helps in measuring the returns of portfolios after adjusting the risk associated i.e. it measures the risk-adjusted return of the different investment portfolio relative to a benchmark. - > negative: underperform - > positive: overperform

Question 38

Describe the Treynor Index

Answer 38

The Treynor Index measures the risk-adjusted performance of an investment portfolio by analyzing a portfolio's excess return per unit of risk. The measure of market risk used is beta, which is a measure of overall market risk or systematic risk. The higher the Treynor Index, the greater "excess return" being generated by the portfolio per each unit of overall market risk.

Question 39

Describe the Jensen’s measure

Answer 39

Jensen's alpha, is a risk-adjusted performance measure that represents the average return on a portfolio or investment, above or below that predicted by the capital asset pricing model (CAPM), given the portfolio's or investment's beta and the average market return

Question 40

Describe the Appraisal ratio (AR) (aka Information Ratio)

Answer 40

Used to measure the quality of a fund manager's investment-picking ability. It compares the fund's alpha to the portfolio's unsystematic risk or residual standard deviation.

Question 41

Describe the Treynor’s Measure and T2

Answer 41

A performance metric for determining how much excess return was generated for each unit of risk taken on by a portfolio.

Question 42

Two dimensions of Active Management

Answer 42

- Market timing • Macro forecasting - Security analysis • Micro forecasting

Question 43

Describe the Treynor-Black Model

Answer 43

Pure CAPM does not hold! There is an alpha. -> two strategies combined: r =(1−w)r(m) +wr(a)

Question 44

What is Company Cost of Capital?

Answer 44

Defined as the expected return on a portfolio of all the company’s existing assets - It is the opportunity cost of capital for investment in the firm’s assets

Question 45

Name two Adjustments to Company Cost of Capital

Answer 45

1. Risk of investment projects may differ from the risk of the firms assets that determine the company cost of capital • Project beta values 2. Adjustment for financial leverage • Risk of equity higher in a leveraged firm

Question 46

What is R^2?

Answer 46

The R^2 of the regression provides an estimate of the proportion of firm risk that can be attributed to market risk -> The balance (1-R^2) can be attributed to firm specific risk.

Question 47

What affects betas?

Answer 47

1. Determinant 1: Product type - > The beta value for a firm depends upon the sensitivity of the demand for its products and services to macroeconomic factors that affect the overall market 2. Determinant 2: Operating leverage effect (FC vs VC) 3. Determinant 3: Financial leverage

Question 48

What do Modigliani & Miller say about cost of capital?

Answer 48

Value of assests does not change with capital structure -> WACC remains constant

Question 49

Difference between alfa and beta?

Answer 49

Beta is a historical measure of volatility. Beta measures how an asset (i.e. a stock, an ETF, or portfolio) moves versus a benchmark (i.e. an index (market)). Alpha is a historical measure of an asset's return on investment compared to the risk adjusted expected return.

Question 50

What is capital market line?

Answer 50

The capital market line (CML) represents portfolios that optimally combine risk and return. Capital asset pricing model (CAPM), depicts the trade-off between risk and return for efficient portfolios. It is a theoretical concept that represents all the portfolios that optimally combine the risk-free rate of return and the market portfolio of risky assets. Under CAPM, all investors will choose a position on the capital market line, in equilibrium, by borrowing or lending at the risk-free rate, since this maximises return for a given level of risk. 1. The capital market line (CML) represents portfolios that optimally combine risk and return. 2. CML is a special case of the CAL where the risk portfolio is the market portfolio. Thus, the slope of the CML is the Sharpe ratio of the market portfolio. 3. The intercept point of CML and efficient frontier would result in the most efficient portfolio called the tangency portfolio. 4. As a generalization, buy assets if sharpe ratio is above CML and sell if sharpe ratio is below CML.

Question 51

What is security market line?

Answer 51

The security market line is the theoretical line on which all capital investments lie. Investors want higher expected returns for more risk.