CAPM (first paper)

Question 1

What is the main goal of Markowitz Portfolio Theory?

Answer 1

To help investors build optimal portfolios that maximize expected return for a given level of risk (or minimize risk for a given return), using mean-variance analysis.

Question 2

How does CAPM build on Markowitz Portfolio Theory?

Answer 2

CAPM takes the portfolio optimization behavior of Markowitz and derives the equilibrium pricing of assets, assuming all investors behave this way.

Question 3

What is the key insight of CAPM regarding risk and return?

Answer 3

Only systematic risk (measured by beta, β) is priced in the market; diversifiable risk is not compensated because it can be eliminated by diversification.

Question 4

What is the CAPM formula for expected return?

Answer 4

E(Rj)=RF+βj[E(RM)−RF]
Where:
RF= risk-free rate
E(RM) = expected market return
βj= sensitivity of asset j to market risk

Question 5

What does CAPM say about asset prices in equilibrium?

Answer 5

Prices will adjust such that the expected return compensates only for systematic risk, not for any diversifiable risk.

Question 6

How do Markowitz and CAPM differ in purpose?

Answer 6

Markowitz helps individual investors choose optimal portfolios.

CAPM explains how asset returns are determined across the market when all investors optimize this way.