L2 - Risk, Return and CAPM

Question 1

Monetary and Percentage Returns?

Answer 1

• Total Monetary Return = Dividend Income + Capital Gains
• Percentage Return = Dividend Yield + Capital Gains Yield

Question 2

What is holding period return over T periods?

Answer 2

Question 3

What is average return?

Answer 3

arithmetic mean of the returns

Question 4

What is Risk?

Answer 4

Question 5

How can your calcuate risk?

Answer 5

Question 6

What is Risk Premium?

Answer 6

• We can compare the average return with returns on other securities (low volatility securities).
• Government bonds have low volatility.
• We call these low volatility securities as risk-free return since they are free of the risk of default.
• The difference between the return on the risky asset and risk-free return is called excess return on the risky asset (risk premium)

Question 7

Definitions of:

1. Expected Return
2. Variance/Standard Deviation
3. Covariance/Correlation

Answer 7

Question 8

Formula for Variance/Standard deviaiton of a securities returns?

Answer 8

Question 9

How do you calculate the Covariance between two securities?

Answer 9

Question 10

How do you calculate the correlation between two securities?

Answer 10

Question 11

What is Total risk made up of?

Answer 11

Question 12

How is does the risk of a portfolio change when more stocks are added to it?

Answer 12

• Final equations breaks down into average variance + average covariance

Question 13

What is CAPM?

Answer 13

Question 14

What are alternative ways of computing β under CAPM?

Answer 14

Question 15

How can we interpret beta in the CAPM?

Answer 15

Question 16

What does CAPM look like on a graph?

Answer 16

• The SML is the graphical representation of the CAPM
  
  • Above SML –> underpriced, get more return for the same level of risk predicted by CAPM, buy
    
    • Forces prices higher reduces E(r) back down to SML
  • Below SML –> overpriced, get less return for the same level of risk predicted by CAPM, short
    
    • Prices fall due to lack of demand, E(r) therefore increase back up to the SML

Question 17

CAPM assumptions?

Answer 17

• Investors hold diversified portfolios (investors are well diversified).
• • Perfect capital market assumptions, e.g.,
  
  • 1. No individual dominates the market,
  • 2. Investors are rational and risk-averse,
  • 3. Investors have perfect information,
  • 4. All investors can borrow or lend at the risk free rate,
  • 5. No transaction or taxation costs,
• • Single-period transaction horizon.

Question 18

Limitations of CAPM?

Answer 18

• Unrealistic assumptions:
  
  • ➢Many investors are not well-diversified
  • ➢Perfect capital market assumptions are unrealistic
    
    • large investors like pension funds and IB can buy large blocks of shares causing fluctuations in prices
    • Investors definitely arent always rational and risk-averse –> YOLO wall street bets
    • Big institutions and Insider Trading –> Some investors have informational advantages
    • There are transaction and taxation costs
• Impossible to hold the true market portfolio so having to hold a proxy for it S&P500 for example
• • Single period model while in reality, investment horizon can be many years.
• • Beta is calculated using historical data without considering what is likely to happen in the future.
• • What is the “market”?

Question 19

What is Blume’s formula?

Answer 19

• Geometric average tells you what youy actually earned per year on average, compunded annually
• The arithmetic average tells you whtat you earned in a typical year
• But when forcasting for the future there is a lot of confusion about which of these averages are better.
  
  • The problem is this: if we have estimates of both the arthemtic mean and goemetirc average returns, then the arithmetic average is probably too high for longer period and the geomettric average is probably too low for shorter periods
• The small the forcast horizon (T) the closer to the Arithmetic average, the closer it is to N, the closer the Blume’s numbers comes to the Geometric Average

T = forcast horizon

N = number of periods