Topic 8 - Valuation of capital assets

Question 1

Researchers have shown that the best measure of the risk of a security in a large portfolio is the

Answer 1

beta (ß) of the security

Beta measures the responsiveness of a security to movements in the market portfolio (i.e., systematic risk)

Question 2

If we accept a linear relationship

Answer 2

Then the model can be represented with a line: The Securities Market Line (SML)

All securities should comply with the model, even the Market Portfolio (M)

Question 3

Expected return on a security

Answer 3

This valuation model is called the Capital Asset Pricing Model (CAPM)

And is represented by the equation of a line: The SML
E(ri) = rf + Bi x (E(rm)-rf)

Question 4

Limitations of the CAPM

Answer 4

• Only one factor to explain returns
• Beta is computed with historical data while it is used to predict future returns: Is beta stable across time?
• The model assumes that the market is in equilibrium and all players diversify efficiently
• The model assumes that the market portfolio is efficient but we really use a proxy

Question 5

The Arbitrage Pricing Theory

Answer 5

a well-known method of estimating the price of an asset

The theory assumes an asset’s return is dependent on various macroeconomic, market and security-specific factors

Question 6

How Arbitrage Pricing Theory works (APT)

Answer 6

it’s an alternative to the capital asset pricing model (CAPM)

Two things can explain the expected return on a financial asset:
1) macroeconomic/security-specific influences
2) asset sensitivity to those influences (betas)

This relationship takes form of the linear regression formula above.
There is an infinite number of security-specific influences. It’s up to the analyst to decide which are relevant to the asset.

Question 7

Differences between CAPM and the APT

Answer 7

• APT applies to well diversified portfolios and not necessarily to individual stocks
• With APT it is possible for some individual stocks to be mispriced - not lie on the SML
• APT is more general in that it gets to an expected return and beta relationship without the assumption of the market portfolio

Question 8

Concept and proposed strategy of the RSI-14

Answer 8

It compares the magnitude of a stock’s future or recent gains to the magnitude of recent losses. It takes the number and turns it into a number ranging between 0 and 100.

RSI = 100 - 100/(1+RS)