chapter 12

Question 1

cost of capital

Answer 1

the best expected return available in the market on investments with similar risk/same beta. it is provided by the SML equation.

Question 2

Capital Asset Pricing Model (CAPM)

Answer 2

provides a practical way to identify an investment with similar risk.

Question 3

market portfolio (CAPM)

Answer 3

under CAPM, the market portfolio is a well-diversified, efficient portfolio representing the non-diversifiable risk in the economy. it is the total supply of securities with the proportions of each security corresponding to the proportion of the total market that each security represents. it is a value-weighted portfolio.

Question 4

beta

Answer 4

sensitivity to market risk. if investments have the same beta, they have similar risk.

Question 5

value-weighted portfolio

Answer 5

a portfolio in which each security is held in proportion to its market capitalisation, eg. the market portfolio.

Question 6

equal-ownership portfolio

Answer 6

a portfolio in which an equal fraction of the total number of shares outstanding of each security is held. a value-weighted portfolio is also an equal-ownership portfolio.

Question 7

passive portfolio

Answer 7

a portfolio where very little trading is required to maintain it. a value-weighted portfolio is also a passive portfolio.

Question 8

market index

Answer 8

reports the value of a particular portfolio of securities.

Question 9

S&P 500

Answer 9

an index that represents a value-weighted portfolio of 500 of the largest US stocks. it represents almost 80% of the US stock market in terms of market capitalisation.

Question 10

Dow Jones Industrial Average (DJIA)

Answer 10

consists of a portfolio of 30 large industrial stocks. it is a price-weighted portfolio.

Question 11

price-weighted portfolio

Answer 11

a portfolio in which an equal number of shares is held of each stock, independent of their size.

Question 12

index funds

Answer 12

funds that invest in portfolios, offered by many mutual fund companies.

Question 13

exchange-traded fund (ETF)

Answer 13

a security that trades directly on an exchange, like a stock, but represents ownership in a portfolio of stocks.

Question 14

market proxy

Answer 14

a portfolio whose return practioners believe closely tracks the true market portfolio.

Question 15

market risk premium

Answer 15

the expected excess return of the market portfolio. it provides the benchmark by which we assess investors’ willingness to hold market risk.

Question 16

US Treasuries

Answer 16

free from default risk, but subject to interest rate risk unless we select a maturity equal to our investment horizon. the yield is often used as the risk-free saving rate in the CAPM model. however, most investors pay a higher rate for borrowing.

Question 17

best-fitting line in a scatterplot

Answer 17

captures the components of a security’s return that we can explain based on market risk, so its slope is the security’s beta.

Question 18

linear regression

Answer 18

the statistical technique that identifies th best-fitting line through a set of points.

Question 19

error/residual term

Answer 19

represents the deviation from the best-fitting line and is zero on average (or else we could improve the fit). it corresponds to the diversifiable risk of the stock.

Question 20

alpha

Answer 20

measures the historical performance of the security relative to the expected return predicted by the security market line. it is the distance the stock’s average return is above or below the SML. it can be interpreted as a risk-adjusted measure of the stock’s historical performance and should not be significantly different from zero.