CAPM essay 1 - "dead or alive"

Question 1

CAPM dead or alive essay structure 1-8.

Answer 1

1.Intro
2. Overview of CAPM and assumptions
3.Predictions and CML and SML
4. How its tested and Time-series regression
5. Issues with the CAPM
6. Support for the CAPM
7. Empirical evidence against CAPM
8.Conclusion

Question 2

Introduction

Answer 2

What is the CAPM and who developed it?
What is the CAPM used for?

Question 3

What does CAPM stand for?

Answer 3

Capital asset pricing model

Question 4

Who developed CAPM?

Answer 4

Sharpe (1964), Lintner (1965), and Mossin (1966)

Question 5

What is the CAPM used for?

Answer 5

Financial model used to describe the relationship between expected returns and risk.

Question 6

What does the CAPM allow us to measure?

Answer 6

As with all financial models it lets us measure systematic risk

Question 7

Systematic vs idiosyncratic risk

Answer 7

Systematic risk cant be diversified away. Idiosyncratic risk can and is risk that is firm or asset specific

Question 8

What represents systematic risk?

Answer 8

Beta, which reflects an assets sensitivity to movements in the overall markets.

Question 9

CAPM equation

Answer 9

Ui=Rf+(Um-Rf)Bi

Ui= Asset return
Rf=risk free rate
Um= market return
Bi=sensitivity

Question 10

Overview of CAPM and assumptions

Answer 10

1. Assumptions
2. Key predictions
3. CML and SML and graphs

Question 11

Key assumptions of the CAPM model?

Answer 11

1. Frictionless and competitive market
   2.Investors are mean variance optimizers
   3.A risk-free asset exists

Question 12

Frictionless market

Answer 12

No trading costs
No taxes
No portfolio costs
Unlimited short selling

Question 13

Competitive market

Answer 13

Investors are price takers and so therefore they can’t manipulate the prices.

Question 14

Investors are mean-variance optimizers

Answer 14

Investors select a portfolio that gives them the maximum expected return given the level of risk

Question 15

A risk-free asset exists

Answer 15

Investors can either borrow or lend at the same risk-free rate

Question 16

Risk-free asset example

Answer 16

Government bonds or treasury bills. Investment with minimal risk of default.
Although in practise these are not truly risk free

Question 17

According to the CAPM what is the sole determinant of returns?

Answer 17

An assets beta

Question 18

What does an assets beta measure?

Answer 18

How sensitive an asset is to the overall market movements.

Question 19

Under these conditions what do investors chose to do?

Answer 19

Allocate between the risk-free asset and the market portfolio with how much in each depending on their risk tolerance.

Question 20

Main two predictions of the CAPM model

Answer 20

Capital Market Line (CML)
Security Market Line (SML)

Question 21

How is the CML derived?

Answer 21

Based on the assumptions of the model.

Question 22

What does the CML represent?

Answer 22

the risk-return tradeoff for efficient portfolios

Question 23

What assets will efficient portfolios contain?

Answer 23

A combination of the risk-free asset and the market portfolio. All investors regardless of risk tolerance are assumed to chose a mix of the two assets

Question 24

How much of each asset will an investor hold?

Answer 24

All investors regardless of risk tolerance are assumed to chose a mix of the two assets.

Question 25

How does risk tolerance change asset consumption?

Answer 25

If an investor is more risk averse they will put more money into the risk-free asset which will move them down the line towards the y axis.

Question 26

What does the market portfolio include?

Answer 26

The market portfolio includes all risky assets is a value weighted portfolio

Question 27

Value weighted portfolio

Answer 27

Allocates assets based on their market capitalisation

Question 28

What point is tangency between the efficient frontier and the CML?

Answer 28

The market portfolio

Question 29

What risk level would someone who invests in the tangency point have?

Answer 29

Average

Question 30

CML graph

Answer 30

See iPad

Question 31

How is the Security Market Line (SML) derived?

Answer 31

From the fact that when in equilibrium all investors will hold cash and the market portfolio as their two assets.

Question 32

What does the SML show?

Answer 32

The expected return of an asset as a function of its beta with the market.

Question 33

How to achieve equilibrium?

Answer 33

Supply=demand every investor will hold an optimal portfolio

Question 34

In equilibrium where will all portfolios be graphically?

Answer 34

All portfolios will lie on the SML

Question 35

Under CAPM if two factors have the same beta what does this mean?

Answer 35

Since systematic risk is the only factor in returns. Two assets with the same beta should have the same expected return, no matter how volatile they are in isolation.

Question 36

SML graph

Answer 36

See iPad

Question 37

Practical application of SML?

Answer 37

Using expected return as a benchmark for: Cost of equity capital estimation Evaluating managed funds Portfolio optimization

Question 38

What does testing the CAPM involve?

Answer 38

Estimating the betas from historical data Looking at whether returns align with SML predictions

Question 39

How to test the CAPM?

Answer 39

One common approach for testing the CAPM is time-series regression.

Question 40

What should alpha (the intercept) be under CAPM?

Answer 40

zero

Question 41

What does alpha show us?

Answer 41

Mispricing

Question 42

What does it mean if alpha is not zero?

Answer 42

Then either the asset is over or under valued relative to its beta and the CAPM has failed.

Question 43

Issues with the CAPM

Answer 43

Roll critique (1977) Estimation risk problem

Question 44

Roll critique (Roll, 1977)

Answer 44

CAPM is actually not testable since the market portfolio cannot be observed

Question 45

What can be used as a proxy for the market portfolio?

Answer 45

Most empirical studies use stock market index. CAPM makes no predictions about proxies

Question 46

Estimation problem risk

Answer 46

True values of beta and um are unknown

Question 47

How are the values calculated?

Answer 47

Using historical data assuming that future cash flows can be estimated from it.

Question 48

If future values could be estimated accurately what would this mean for CAPM?

Answer 48

CAPM would not be necessary

Question 49

Support for the CAPM

Answer 49

Levy (2012) argues that CAPM is still useful even though beta may not fully explain returns

Question 50

What does Levy(2012) suggest CAPM is useful for?

Answer 50

Benchmarking Cost of capital estimations Portfolio theory optimization

Question 51

Fama and French (1992) opposing CAPM

Answer 51

Fama and French (1992) find no relation between average returns and betas in U.S stock returns

Question 52

Empirical evidence against the CAPM Campbell, Liu, and Zhu, (2016)

Answer 52

Campbell, Lie, and Zhu (2016) find that a large number of stock characteristics have been found that help explain cross-sectional returns beyond the market beta.

Question 53

Conclusion

Answer 53

CAPM has weaknesses compared to other financial models e.g. APT or Fama French 5 factor model (2015)

Question 54

While CAPM lacks precision what's good about it according to Harvey and Lie (2020)

Answer 54

Harvey and Liu (2020) find that while CAPM lacks precision it is often the best single factor model when simplicity is required.