CAPM Flashcards
(14 cards)
What does the beta (β) represent in CAPM?
Beta measures the asset’s sensitivity to market movements (systematic risk).
How do you interpret a positive alpha in CAPM?
The asset is underpriced; its expected return is higher than the required return.
What is the significance of the market portfolio in the CAPM framework?
The market portfolio represents the optimal combination of all risky assets. Under CAPM, every investor holds this portfolio in the same proportions as its overall market value, making it the benchmark for pricing risk.
Why is only systematic risk priced in CAPM?
Unsystematic risk can be diversified away; investors are only compensated for non-diversifiable risk.
What happens if all assets are fairly priced under CAPM?
All assets and portfolios lie exactly on the Security Market Line (SML), and alpha = 0.
What does a parallel shift in the SML represent?
A change in the nominal risk-free rate, affecting all required returns equally.
What is alpha in CAPM terms?
The difference between a security’s expected return and its required return (CAPM prediction).
What does the Capital Market Line (CML) represent?
The special CAL that uses the market portfolio as the risky asset.
What is an optimal risky portfolio?
It is the portfolio on the efficient frontier that offers the highest Sharpe ratio (maximizes return per unit of risk) when combined with a risk-free asset.
What is an optimal complete portfolio?
It combines the optimal risky portfolio with the investor’s risk-free asset allocation based on their risk aversion to maximize utility.
What is the CAL?
The Capital Allocation Line represents the risk-return combinations available by combining a risky portfolio with a risk-free asset.
What assets lie on the CML?
Efficient portfolios only — portfolios that are a combination of the market and the risk-free asset.
What is the SML?
The Security Market Line plots the relationship between expected return and beta under CAPM.
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What’s the key difference between CML and SML?
CML uses total risk (σ) and applies only to efficient portfolios; SML uses systematic risk (β) and applies to individual securities and portfolios.
