Capital Asset Pricing Model Flashcards
If you add a new investment to a portfolio, what will be the contribution of that new investment to the portfolio’s volatility?
Corr(Ri,Rp)*SD(Ri)
On what condition will you add the new investment to the portfolio?
If the new investment increases the Sharpe ratio of the portfolio.
What are the assumptions of the CAPM?
- Efficient transactions
- Rationality
- Homogeneous expectations
What does the “efficient transaction” hypothesis implies?
No transaction costs and borrow/lend at risk-free rate
What does the “rationality” hypothesis implies?
Investors hold the efficient portfolio
What is an efficient portfolio?
Portfolio that maximises the Sharpe ratio.
What does the “homogeneous expectations” hypothesis implies?
investors have homogeneous expectation regarding returns, volatility and correlations of securities.
To the CAPM, which portfolio is the efficient portfolio?
The market portfolio.
What is the market portfolio?
Portfolio consisting of all available securities on the market weighted by their market capitalization.
What is the slope of the Capital Market Line and what types of portfolios are on that line?
Slope = Sharpe ratio of the market portfolio
Only EFFICIENT portfolios are on the CML
Compared to the CML, where do individual investments plot in a graph with volatility on the horizontal axis and expected return on the vertical axis?
Individual investments plot BELOW the CML :
. the Sharpe ratio of an individual investment in lower - slope is lower)
. The volatility of individual investment includes market risk and idiosyncratic risk (not correlated to the market)
What does the beta of a stock represent?
Change in the return of the stock per unit change in the return of the market portfolio.
What is the Security Market Line and what is its slope?
Line in a graph of return over beta.
Its slope is the risk premium of the market portfolio
What type fo investments are on the SML if CAPM holds?
ALL investments are on the SML in CAPM holds.
