CAPM Financial Model Overview

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Questions and Answers

What are the two main ways investors need to be compensated according to the CAPM?

Investors need to be compensated for the time value of money and for risk.

How does CAPM assist in portfolio management?

CAPM helps determine the theoretically appropriate required rate of return for an asset, aiding decisions on asset addition to a diversified portfolio.

Explain the significance of the Security Market Line (SML) in CAPM.

The SML shows the relationship between expected return and systematic risk, allowing investors to evaluate whether an asset is fairly priced.

What might cause the Treynor and Sharpe ratios to give conflicting performance rankings?

The Treynor ratio uses systematic risk, while the Sharpe ratio uses total risk, leading to potential discrepancies in rankings. Signup and view all the answers

What are the four or five factors that typically explain most of a security's return?

Surprises in inflation, GNP, investor confidence, and shifts in the yield curve. Signup and view all the answers

What is the primary purpose of the Capital Asset Pricing Model (CAPM)?

The primary purpose of CAPM is to determine how an investment's risk affects its expected return. Signup and view all the answers

Explain the significance of the beta (β) in the Capital Asset Pricing Model.

Beta (β) measures an asset's sensitivity to non-diversifiable risk, indicating its risk level relative to the market. Signup and view all the answers

What assumption does CAPM make regarding risk that can be diversified?

CAPM assumes that risk that can be diversified away is not considered a threat to asset prices. Signup and view all the answers

List two key historical figures associated with the development of the CAPM.

William Sharpe and Jack Treynor are two key figures associated with the development of CAPM. Signup and view all the answers

What does the Security Market Line represent in the context of CAPM?

The Security Market Line (SML) represents the relationship between risk and expected return in a graphical form. Signup and view all the answers

Discuss one major limitation of the Capital Asset Pricing Model as indicated by empirical tests.

One major limitation is that CAPM has failed numerous empirical tests, calling into question its predictive accuracy. Signup and view all the answers

In CAPM, why are zero transaction costs important?

Zero transaction costs are important because they enable diversification, eliminating idiosyncratic risk. Signup and view all the answers

What is one reason CAPM remains popular despite more modern asset pricing theories?

CAPM remains popular due to its simplicity and utility in a variety of financial situations. Signup and view all the answers

What does beta represent in the Capital Asset Pricing Model (CAPM)?

Beta represents the systematic risk of a security and its future volatility in relation to the market. Signup and view all the answers

Why are historical betas considered unreliable for predicting future risk for individual stocks?

Historical betas are unstable for individual stocks, making them poor estimators of future risk. Signup and view all the answers

What does a constant risk-return proportionality ratio of 0.5 indicate?

It indicates that one unit of risk premium is accompanied by 0.5 units of risk. Signup and view all the answers

How does the stability of betas differ between individual stocks and portfolios?

Individual stock betas are unstable, while betas of portfolios with ten or more stocks are reasonably stable. Signup and view all the answers

How is systematic risk measured and why is it important?

Systematic risk is measured by beta, which is important because it reflects the sensitivity of a security's returns to market movements. Signup and view all the answers

What did empirical studies generally reveal about the relationship between expected return and systematic risk?

Empirical studies showed a significant positive relationship between expected return and systematic risk, though the slope is usually less than predicted by CAPM. Signup and view all the answers

According to the CAPM, what type of risk is considered irrelevant and why?

Unsystematic risk is considered irrelevant in CAPM, as it does not affect the expected returns based on the model's premises. Signup and view all the answers

What role does the capital market line play in understanding efficient portfolios?

The capital market line shows the risk-return relationship of efficient portfolios, indicating the optimal return for a given level of risk. Signup and view all the answers

What happens to the variance of a market portfolio when an additional security is added?

The variance of the market portfolio will increase, as it includes the weighted sum of the co-variances of all individual securities. Signup and view all the answers

What is Richard Roll's perspective on the testability of the CAPM?

Richard Roll argues that the ambiguity of the market portfolio renders the CAPM untestable. Signup and view all the answers

What systematic issue do researchers face when assessing the relative importance of market and company risk?

Researchers often find that the relationship between risk and returns reflects more statistical problems than the true nature of the capital market. Signup and view all the answers

What is the relationship between the expected return of a security and its beta according to the SML?

The expected return of a security is directly proportional to its beta, as expressed in the equation Ri = Rf + βi (Rm - Rf). Signup and view all the answers

What does the linearity observed in the risk/return relationship indicate about CAPM?

The observed linearity suggests that the risk/return relationship is consistent, with no significant curvature indicating deviations from theory. Signup and view all the answers

Why is unsystematic risk not a concern when examining the risk of a portfolio?

Unsystematic risk can be diversified away, making it less relevant compared to systematic risk. Signup and view all the answers

What does the covariance between a security's return and the market portfolio's return measure?

It measures the risk of the security in relation to the overall market. Signup and view all the answers

How is the expected return of a security derived using the covariance method?

It is derived using the equation Ri = Rf + (Rm-Rf/σm) (Covim/σm). Signup and view all the answers

Who were the key developers of the Capital Asset Pricing Model (CAPM)?

Jack Treynor, William F. Sharpe, John Lintner, and Jan Mossin. Signup and view all the answers

What assumption does Black CAPM make regarding riskless assets?

Black CAPM does not assume the existence of a riskless asset. Signup and view all the answers

List three assumptions of investors according to CAPM.

Investors aim to maximize economic utilities, are rational and risk-averse, and are broadly diversified. Signup and view all the answers

What is the significance of lenders and borrowers in the context of CAPM?

Investors can borrow or lend unlimited amounts at the risk-free rate, allowing them to create desired risk-return portfolios. Signup and view all the answers

Explain the formula for expected return in a risky and risk-free asset combination.

The expected return is given by $R_p = R_fX_f + R_m(1-X_f)$. Signup and view all the answers

What does it mean that investors are 'price takers' in CAPM?

It means they cannot influence prices and must accept the market prices as given. Signup and view all the answers

What role does diversification play in the assumptions of CAPM?

Diversification helps investors spread risk across various investments, adhering to the assumption of being broadly diversified. Signup and view all the answers

How do homogeneous expectations affect investor behavior in CAPM?

Homogeneous expectations mean all investors have the same predictions about future returns and risks, leading to uniform decision-making. Signup and view all the answers

Why do different market indices yield different betas for the same security?

Different indices capture varying levels of market volatility and market conditions, leading to different beta calculations for the same security. Signup and view all the answers

What implications does the introduction of bonds have on the validity of the CAPM?

Bonds do not fall on the security market line, suggesting that CAPM may not universally apply to all financial assets, especially fixed-income securities. Signup and view all the answers

How has CAPM been beneficial for investment analysts?

CAPM aids analysts in selecting securities and portfolios based on their expected returns and market risk, identifying overvalued and undervalued assets. Signup and view all the answers

What basic assumption of CAPM is critiqued regarding its inputs?

Critics argue that CAPM's ex-ante assumptions require future expectations, yet empirical tests often use ex-post data, leading to potential inaccuracies. Signup and view all the answers

How does the variability of historical data affect the beta value in the CAPM model?

The historical data regarding market returns and risk-free rates can vary across different time periods, directly influencing the beta estimation. Signup and view all the answers

Briefly explain the premise of Arbitrage Pricing Theory (APT).

APT posits that the expected return of a financial asset is a linear function of multiple macro-economic factors, with sensitivities represented by specific betas. Signup and view all the answers

What does CAPM primarily focus on when evaluating investments?

CAPM primarily focuses on market risk, prompting investors to assess the relative riskiness of different assets in the market. Signup and view all the answers

Why do some analysts criticize CAPM despite its widespread use?

Critics highlight that CAPM's reliance on expected future conditions can lead to inaccuracies when actual market behaviors differ. Signup and view all the answers

Study Notes

Capital Asset Pricing Model (CAPM)

CAPM is a financial model used to determine the expected return on an asset, based on its systematic risk.
It was developed in the early 1960s by William Sharpe, Jack Treynor, John Lintner, and Jan Mossin.
CAPM considers systematic risk (non-diversifiable risk), which is the risk associated with the overall market, and not diversifiable risk.
It assumes investors are rational, risk-averse, and have homogeneous expectations.
It assumes investors can borrow and lend at a risk-free rate.

Assumptions of CAPM

Investors aim to maximize utility (given fixed asset quantities).
Investors are rational and risk-averse.
Investors are broadly diversified across their investments.
Investors are price takers (can't influence prices).
Unlimited borrowing and lending at a risk-free rate is possible.
Trading has no transaction costs or taxation.
Securities are perfectly divisible and liquid.
Homogeneous Expectations
All information is available to all investors at the same time.

Lending and Borrowing

Investors can borrow and lend at a risk-free interest rate.
This allows investors to create a risk-return combination by mixing risk-free assets with risky assets in a portfolio.

Risk-Return Trade-Off

The expected return of a portfolio is a combination of the risk-free rate and the return of risky assets, weighted by the proportion of investment in each.
Higher risk typically leads to higher expected returns.

Security Market Line (SML)

Represents the relationship between expected return and systematic risk (beta) for securities in an efficient portfolio.
Securities on the SML are fairly valued.
If above the SML, the security is undervalued

Empirical Tests of CAPM

Empirical tests have shown mixed results, suggesting the CAPM may not perfectly reflect real-world market conditions.
Betas of individual securities are often unstable.
Portfolios with more securities tend to have more stable betas.

Arbitrage Pricing Theory (APT)

APT is an alternative asset pricing model that suggests expected returns are a function of macroeconomic factors and the sensitivity of the asset to these factors.
APT is more flexible than CAPM, but is often more complex to apply in real-world situations.

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Description

This quiz explores the Capital Asset Pricing Model (CAPM), a fundamental concept in finance developed in the 1960s. It covers key assumptions, risk considerations, and the rational behaviors of investors within this framework. Test your understanding of how CAPM aids in determining expected asset returns based on systematic risk.