Capital Market ADVANCED

Question 1

What are the three elements of Capitalism?

Answer 1

• Well defined property rights
• Market Driven Competition
• Profit Seeking firms (reduction in transaction costs)

Question 2

What are the assumptions for the CAPM?

Answer 2

• Investors are rational and risk averse
• Investors have a ‘one-period investment horizon’
• Investors have homogenous expectations
• Investors have access to borrowing/lending
• Market has perfect competition with no transaction costs or taxes

Question 3

How can you derive the CAPM?

Answer 3

• Starting with N risky assets: Maximise expected utility subject to the return of a portfolion (ΣωiRi)
• Indifference curves meet the efficiency frontier to give the most efficient portfolio
• Provides the best tradeoff between return and risk
• Now including a risk-free asset sees a Capital Market line (CML)
• Mutual fund theorem: Investors can do as well holding only 2 assets (Rf and optimal portfolio) than all assets- borrow/lending at Rf depending on risk appetite
• CML must be tangental to the curve

Question 4

What is a stock’s Beta (β)? How did it come about?

Answer 4

• Sharpe constructed a hypothetical portfolio, consisting of the tangency portfolio and a risky asset
• Gives the relationship of:
  [σm(E(Ri-E(Rm)))] / [σim - σm²] = [(E(Ri-E(Rm))] / [σm]
• This allows us to derive the CAPM formula
• Beta = σim / σm², and illustrates the responsiveness of a stock to a change in the market
• β>1 suggests that an asset is more risky than a portfolio

Question 5

How can a Neo-classical model be used to evaluate the impacts on the financial markets [MATHS]?

Answer 5

• CAPM determines price, Neoclassical determines impact
• MaxU = lnC + βlnC’ SUBJECT TO: c = y+b and c’=y’-b(1+r)
• Substitute the constraints into the objective and differnentiate to find:
  b = [y’ - β(1+r)y] / [(1+r)(1+β)]

Question 6

What is the Gini Coefficient? How can it be calculated?

Answer 6

• Gini Coefficient: Quantifies the degree of inequality (0=equal)
• Gini Coefficient: A/A+B- as A rises/B falls, Gini coefficient rises
• A is the space between the LOPE (45) and the Lorenz Curve, B is the space under the Lorenz Curve
• To calculate, split B into triangles/trapeziums and find A from subtracting B from 0.5 [A+B = 0.5]

Question 7

What is the difference between arithmetic growth and exponential growth? What is the implications of this?

Answer 7

• ARITHMETIC: Used to model how workers accumulate wealth
• Wealth in 2 periods has difference of d
• Iterating backwards, we get to a point where: Yt = Y0 + td
• EXPONENTIAL: Used to model how capitalist accumulate wealth
• Wealth in 2 periods have a ratio of q
• Iterating backwards, we get to a point where: Yt = Y0 +q^t, where q = 1+r
• This leads to capitalists rapidly outgrowing workers in wealth accumulation