Self Study Questions Topic 2

Question 1

CAPM formula

Answer 1

Question 2

Beta Calculation

Answer 2

covariance of asset j with market divided by variance of the market

Question 3

What does the Security Market line (SML) plot?

Answer 3

expected return vs beta (systematic risk)

Question 4

SML

Answer 4

line on the CAPM (plots expected return vs beta)

plotting: risk free rate, market portfolio, assets

Question 5

APT single-factor model

Answer 5

Question 6

slope of SML

Answer 6

expected return in the market - risk free rate

(the market risk premium)

Question 7

APT two-factor model

Answer 7

Question 8

Key difference between CAPM and APT
(ADD IN OTHER DIFFERENCES!!!)

Answer 8

• CAPM uses one market factor; APT allows multiple macroeconomic factors
• APT = dynamic
• CAPM = equilibrium
• APT assume - opp to increse return without risk & each return depends on unknown number of unknown factors

Question 9

Assumptions of CAPM & MF

Answer 9

Question 10

risk premium

Answer 10

Question 11

Answer 11

Question 12

APT-in equilibrium and CAPM (1 factor case)

Answer 12

Question 13

beta of M and beta of the Risk Free Rate

Answer 13

M - beta is 1 (market is unit sensitive to itself)

Rf - beta is zero (risk free)

Question 14

compare & contrast sigma vs beta

Answer 14

sigma:
-total risk
- broader
- variability in returns around expected value (std deviation)
- zero or positive
- not compensated by market
- non linear combinations

beta:
- systematic risk
- narrower
- sensitivity of returns to changes in return on market portfolio
- covariance of returns between share and market portfolio divided by variance of returns on market portfolio
- zero/positive or negative range
- compensated by market
- linear combinations

Question 15

levels of beta

Answer 15

> 1 = sensitive to market/similar

1 = of unit sensitivity to the market

0< x <1 = low sensitivity to market

negative = hedge for the market

• invest positive beta = if market expected rise

Question 16

Van Zijl extension of CAPM

Answer 16

2 equations!

Question 17

zero beta CAPM

Answer 17

Question 18

assumptions of APT

Answer 18

1. investor opp to increase return without increasing risk will be taken
   (only argument here = transaction costs)
2. each asset return depends upon unknown number of unknown factors (macroeconomic) factors

Question 19

APT vs CAPM

Answer 19

dynamic vs equilibrium

assumption = APT 2 vs CAPM = 8 none true

factors: APT = any number vs CAPM = one asset specific factor

Question 20

variance of returns, M

Answer 20

Question 21

covariance of returns A with M

Answer 21

Question 22

covariance of returns B with M

Answer 22

Question 23

characteristic line

Answer 23

beta is the slope

Question 24

diversification

Answer 24

Question 25

whether lie above or below CML (actual vs implied returns on CML)

Answer 25

actual < implied = lies below CML actual = implied = lies on CML ( only M) actual > implied = lies above CML

Question 26

arbitrage & models & an arbitrage portfolio

Answer 26

1. zero additional investment 2. zero factor sensitivity (factor 1) 3. zero factor sensitivity (factor 2) - simultaneous equations - ratio solution = if positive = arbitrage portfolio

Question 27

Famma french 3 Factor model

Answer 27

3 factors = size and value and systematic risk variance in returns better explained

Question 28

Carhart 4 factor model

Answer 28

adds a momentum factor to Famma French

Question 29

Critique of CAPM

Answer 29

unrealistic assumptions backward looking market proxy issues

Question 30

plotting on CML

Answer 30

CML plot efficient portfolios (only combinations of risk free and market portfolio) individual assets = below CML

Question 31

efficient portfolios

Answer 31

efficient = highest possible return for risk or lowest risk for level of return