Topic 5: Asset Pricing Models

Question 1

How is the CAPM derived and what does it show?

Answer 1

• Derived using principles of diversification with simplified assumptions
• Showing the relationship between risk and
  expected return of an asset

Question 2

What researchers are credited with its development?

Answer 2

Markowitz, Sharpe, Lintner and Mossin

Question 3

What are the first 3 assumptions of the CAPM?

Answer 3

1) Individual investors are price takers
2) Single-period investment horizon (ignoring anything that might happen afterwards)
3) Investments are limited to traded financial assets (can borrow or lend at risk-free rate)

Question 4

What are the last 4 assumptions of the CAPM?

Answer 4

4) No taxes and transaction costs
5) Investors are rational mean-variance optimizers
6) There are homogeneous expectations
7) Information is costless and available to all investors

Question 5

What is the market portfolio?

Answer 5

• Market portfolio contains all securities and the proportion of each security is its market value as a percentage of total market value

Question 6

What does CAPM assume about risk premiums?

Answer 6

• assumes that appropriate risk premium on an asset will be determined by its contribution to the risk of investors’ overall portfolios

Question 7

The variance of the portfolio is …….?

Answer 7

• The sum of all elements

Question 8

What does beta measure?

Answer 8

• Beta measures the stock’s contribution to the variance of the market portfolio

Question 9

what does the CML graph?

Answer 9

• CML graphs the risk premiums of efficient portfolios as a function of portfolio standard deviation

Question 10

What does the SML graph?

Answer 10

• SML graphs individual asset risk premiums as a function of asset risk; the measure of risk for individual assets held as parts of well-diversified portfolios is the contribution of the asset to the portfolio variance (beta)

Question 11

How can CAPM be used to analyse securities?

Answer 11

• portfolio manager will increase the weights of securities with positive alphas and decrease the weights of securities with negative alphas

Question 12

How is CAPM is useful in project or asset valuation?

Answer 12

• useful in asset or project valuation by providing required rate of return (NPV valuation; DDM valuation)

Question 13

Is the condition of zero alphas for all stocks as implied by the CAPM met?

Answer 13

• Not perfect but one of the best available

Question 14

is CAPM testable?

Answer 14

• Proxies must be used for the market portfolio

Question 15

Is CAPM still considered one of the best available description of security pricing and is widely accepted

Answer 15

• Yes

Question 16

Whats the difference between beta in CAPM and beta in single index model?

Answer 16

• They look the same, however, CAPM measures expected returns, while single index model measures real/historical returns

Question 17

The CAPM states that the expected value of alpha

should be what for all securities?

Answer 17

• Zero

Question 18

The index model
holds that the realized value of alpha should
average out to _____ for a sample of historical
observed returns

Answer 18

• Zero

Question 19

What does ‘m’ stand for in the two different models?

Answer 19

• In single index model, “m” stands for a market
  index
• In CAPM, “m” stands for the whole market, which consists of all securities in the market

Question 20

How can arbitrage arise?

Answer 20

• arises if an investor can construct a
  zero investment portfolio with a sure profit
  
  • Since no investment is required, an investor can create large positions to secure large levels of profit

Question 21

Unlike CAPM, what does APT not assume?

Answer 21

• Single-period investment horizon
• Absence of personal taxes
• Risk-free borrowing or lending
• Mean-variance decisions

Question 22

Whats the most important thing with the APT model?

Answer 22

• the deviations of the factors from their expected values.

Question 23

3 comparisons between APT and CAPM

Answer 23

• APT applies to well diversified portfolios and
  not necessarily to individual stocks
• APT is more general in that it gets to an
  expected return and beta relationship without
  the assumption of the market portfolio
• APT can be extended to multifactor models