Flashcards in BKM Chapter 9 Deck (48)

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1

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Main uses for CAPM (2)

(BKM - 9)

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1. benchmark ROR for evaluating potential investments

2. estimating the expected return on assets not yet traded in the marketplace

2

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CAPM assumptions about individual behavior (3)

(BKM - 9)

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all investors:

1. are mean-variance optimizers

2. have investment horizon = 1 period

3. use identical input lists (b/c all relevant info is publicly available)

3

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CAPM assumptions about market structure (4)

(BKM - 9)

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1. all assets are publicly held & traded on public exchanges

2. investors can borrow/lend at the risk-free rate and short positions are allowed

3. no taxes

4. no transaction costs

4

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Categories of CAPM assumptions (2)

(BKM - 9)

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1. individual behavior

2. market structure

5

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Key results of CAPM (3)

(BKM - 9)

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all investors arrive at identical efficient frontiers (based on assumptions)

>> all have identical CALs

>> all have identical optimal risky portfolios = market portfolio

6

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Each investor's CAL under CAPM

(BKM - 9)

### CAL = CML

7

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Reason portfolio managers hold risky portfolios <> market portfolio in reality

(BKM - 9)

### b/c of differences in input lists

8

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Which stocks are included in the market portfolio under CAPM?

(BKM - 9)

### all stocks

9

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Expected risk premium of the market portfolio under CAPM (alternative formula)

(BKM - 9)

###
E[R(M)] = A-bar * sigma^2(M)

where A-bar = average risk aversion of all investors and y* = 1

10

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CAPM assumption about expected returns of individual securities

(BKM - 9)

### an individual asset's risk premium is determined by it's contribution to total risk

11

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Market price of risk

(BKM - 9)

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reward-to-risk ratio for the efficient portfolio (= market portfolio)

= market risk premium / market variance

12

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Classic CAPM formula (aka mean-beta relationship)

(BKM - 9)

### E[r(i)] = risk-free rate + beta * market risk premium

13

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What does beta measure?

(BKM - 9)

### measures the contribution of the individual asset to the variance of the market portfolio

14

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Difference between CAPM and the single-index model

(BKM - 9)

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CAPM assumes every stock has alpha = 0

with rebalancing (so all alpha's = 0) both will end at the same optimal risky portfolios = market portfolio

15

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Mean-beta relationship and the security market line (SML)

(BKM - 9)

###
plots expected returns on the y-axis and beta on the x-axis

SML has slope = market risk premium

y-intercept = risk-free rate

E[r(M)] = return when beta = 1

individual stocks fall above/below the SML depending on their alphas (positive > above)

16

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Alpha and CAPM

(BKM - 9)

###
alpha = difference b/w an individual stock's expected return and the SML (required return from CAPM)

alpha = investor forecast return - CAPM return

17

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Interpretation of the SML

(BKM - 9)

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required return under CAPM for the associated beta

(all fairly priced securities live on the SML)

18

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Difference b/w the SML and the CML

(BKM - 9)

### SML can be used for individual assets and efficient portfolios vs. CML which can only be used for efficient portfolios (b/c the x-axis is standard deviation, which isn't appropriate for individual assets)

19

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Reasons short positions are harder to take than long positions (3)

(BKM - 9)

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1. large amount of collateral needed

2. limited supply may restrict short positions

3. short positions are prohibited for some investment companies

20

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Short position

(BKM - 9)

### borrowing a stock & immediately selling it, betting the price will decrease before the debt is owed

21

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When to use the zero-beta model of CAPM?

(BKM - 9)

### with restrictions on borrowing/borrowing rate <> risk-free rate

22

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Problem with the assumption about borrowing at the risk-free rate under CAPM

(BKM - 9)

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in reality, there may be higher rates on borrowing than lending

>> means that borrowers & lenders may have different optimal risky portfolios <> market portfolio

23

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Characteristics of efficient portfolios (3)

(BKM - 9)

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1. combining efficient portfolios produces an efficient portfolio

2. the market portfolio is an aggregation of efficient portfolios, therefore it is efficient

3. every efficient portfolio (except the global min. variance portfolio) has a companion portfolio on the bottom half of the min-variance frontier with which it is uncorrelated

24

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Zero-beta portfolios

(BKM - 9)

### uncorrelated companion portfolios on the bottom half of the min-variance frontier

25

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Zero-beta version of CAPM

(BKM - 9)

### replaces risk-free rate in regular CAPM with the expected return for the zero beta portfolio

26

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Zero-beta SML and market risk premium compared to regular CAPM

(BKM - 9)

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SML is flatter than the regular SML

market risk premium < under normal CAPM (smaller reward for systematic risk)

27

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Types of assets that are not tradeable (2)

(BKM - 9)

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1. private businesses

2. human capital (e.g. individual earning power)

28

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Mean-beta relationship considering the size of labor income

(BKM - 9)

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E[R] = E[R(M)] * [Cov(excess stock return, excess market return) + P(H)/P(M) * Cov(excess stock return, excess return on HC)] / [market variance + Cov(excess market return, excess return on HC)]

P(H) = value of aggregate human capital

P(M) = market value of traded assets

HC = aggregate human capital

**uses excess returns

29

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Extra-market risks

(BKM - 9)

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inflation or changes in parameters describing future investment opportunities

ex: interest rates, future energy costs, volatility, market risk premium, betas

30