CAPM

Question 1

What are Assumptions of Diversification & Risk?

Answer 1

· All securities have constant variance and covariance
· All securities are equally weighted in portfolio.

Question 2

What does the Sharp Ratio Measure?

Answer 2

Measures the ratio of reward-to-volatility provided by a portfolio.
Highest sharp ratio = tangent portfolio
(E(Rp) - Rf) / SEp

Question 3

What are the Assumptions of CAPM

Answer 3

Investors buy & sell securities at competitive market prices
No taxes/transaction costs
Borrowing at the same rate.
Investors are risk averse & rational
Homogenous markets

Question 4

What is CAPM?

Answer 4

Model used to determine the E(R) on an asset based on its systematic risk.

Question 5

Criticisms of CAPM:

Answer 5

CAPM is an ex-ante theory (focus on future) with ex-post testing (past data)
Assumes every investor is rational
Assumes makrets are perfectly efficient
Model assumes no taxes or transaction costs
Beta is not always precise, varies over time