capm Flashcards
what does ~CAPM calculate
The capital asset pricing model - or CAPM - is a financial model that calculates the expected rate of return for an asset or investment.
LImitations of CAPM
making unrealistic assumptions and relying on a linear interpretation of risk vs. return.
what is volatility in finance?
In finance, it means how much the price of something (like a stock) goes up and down. High volatility means big swings, low volatility means it’s more steady.
why is volatility important?
Volatility is crucial because it helps us understand how risky or stable an investment is. If something is very volatile, it can be exciting (potential for big gains!) but also risky (potential for big losses). On the other hand, if it’s not very volatile, it might be safer but with less chance for big gains.
How would you measure it in a more sophisticated way?
One common way to measure volatility in finance is to use something called standard deviation.
If the numbers are all over the place, the standard deviation is high, indicating high volatility. If they’re close together, it’s low volatility.
What is the Market Portfolio?
In theory, the market portfolio consists of all risky assets. In practice, it is proxied by a stock market index.
How is the financial risk, i.e. volatility, of individual financial assets, such as shares, normally measured
Volatility is measured in terms of Beta.
It is important to note that Beta and NOT variance or standard deviation is the appropriate measure of risk here. Beta risk measures only undiversifiable risk, while variance or standard deviation of return measures both diversifiable and undiversifiable risk.
How can the volatility risk of individual assets be avoided by investors?
It can be avoided by holding a diversified portfolio. Standard deviation risk falls as more assets are added to the portfolio.
What is undiversifiable risk usually measured relative to?
Undiversifiable risk, also known as systematic or market risk, refers to the risk that is inherent to the entire market or a market segment. It cannot be eliminated through diversification because it is associated with external factors that affect the overall market.
In theory it is measured relative to the market portfolio. In practice, it is measured relative to a stock market index such as the FTSE, Dow-Jones, Nikkei etc.
What is the equation of the security market line and what does it tell us about risk–return? The equation that links all these together is known as the…
The equation that links all these together is known as the security market line (SML). The SML is as follows:
E(Ri) = Rf + Bi(E(Rm) – E(Rf))
The equation says that the expected return on share ‘i’ depends on risk free rate plus beta times the market risk premium.
