CAPM Flashcards
What is the formula for expected return?
Rf + β(Rm - Rf)
Rf = risk free rate
Rm = Expected market return
β = measure of risk
What is risk free rate?
The return on a hypothetical investment with no risk
What is the required return formula?
Rf + RP
Rf = risk free rate
RP = risk premium
What is the Expected return formula?
WfRf+WmE(Rm)
E = expectation operator
Rp = return on portfolio
Wf = share of risk free asset in portfolio
Rf = return on the risk free asset
Wm = share of market portfolio in portfolio
Rm = return on the market portfolio
What is unsystematic risk?
Unique risk
What is systematic risk?
Market risk
What does σ mean?
standard deviation
What does β mean?
Measures the covariance between the returns on a particular share with returns on the market as a whole
If β is 1 then:
A 1 percent change in the market index return generally leads to a 1 percent change in the return on the share
if 0 < β < 1 then:
A 1 percent change in the market index return generally leads to a less than 1 percent change in the returns on a specific share
If β > 1 then:
A 1 percent change in the market index generally leads to a greater then 1% return on a specific share
What are 2 applications of CAPM?
- Investment in financial markets
- Calculating the required rate of return on a firm’s investment projects
What are some unrealistic assumptions of CAPM?
- Investors are rational utility maximisers
- Information is freely available
- Investors can borrow and lend at the risk free rate
- Capital markets are perfectly competitive and frictionless
- Securities are infinitely divisible
