Chapter 9 CAPM Flashcards Preview

FN1 corporate finance > Chapter 9 CAPM > Flashcards

Flashcards in Chapter 9 CAPM Deck (23)
Loading flashcards...


helps to answer the question what premium should this investment be so that it can be a competitive investment compared to other investments (cost of equity)


risk-averse investors require what in order to invest

a risk premium (higher percentage, rate) to be given an incentive to accept risk


what are insurance premiums

investors pay this insurance premium to get out of risky situations, therefore we conclude that investors will only choose portfolios tha tare members of the efficient frontier


risk-free asset's return how does their sd and correlation look

they do not vary,
the standard deviation is zero
- correlation between risk free and a portfolio a is also zero


SD increase in direct what

proportion to the amount invested in the risky asset


portfolios of risky securities that lie along the efficient frontier - that is on the curve above te minimum variance portfolio are (MVP) are

efficient and dominate all other possible portfolios of risky securities
- these portfolios offer the highest expected rate of return


what is risk premium

the expected payoff that induces a risk-averse person to enter into a risky situation


Investors will only choose what portfolios

on the efficiency frontier that are above MVP


portfolios on flatter lines are what

are chosen by less risk-averse investors


portfolios higher or steeper than others

investors will require a higher return


how do investors differ

in their risk aversion


what is the formula to estimate the expected return on a portfolio

ERp = RF + W(ERa - RF)

ERpexpected return on portfolio that starts out with w = 0
RF - risk free rate
ERa -


the higher the portfolio allocation (weight) directed to the risky asset

the higher the portfolio risk


if w=0

this is the risk free rate or T-bill amount


Tangent portfolio - definition

the risky portfolio on the efficient frontier whose tangent line cuts the vertical axis at the risk-free rate


new (or super) efficient frontier

portfolios composed of the risk-free rate and the tangent portfolio that offer the highest expected rate of return for any given level of risk


what is negative or short position

a negative position in an asset; the investor achieves a short position by borrowing part of the asset's purchase price form the stockbroker


what is margin

means the investor borrows part of the purchase price from the stockbroker
some stocks have margin requirements as low as 30%, indicating an investor could buy $1,000 worth of stocks by investing only $300 and borrowing the reaming $700 form the broker
- in this case, the portfolio weights are w = 1,000 / 300 or 333% in the risky asset and -233% in the risk-free asset


what is the bad part about margin

the investor pays interest on the borrowed amount
- investor is called a short seller


what sort of other risks do short sellers are subject to

1. experiencing unlimited losses
2. risking being asked to "cover" their short position ( by purchasing the amount of shares sold)
3. having to cover dividends paid on the underlying stock while they are in the short position


separation theorem

the theory that the investment decision (how to construct the portfolio of risky assets) is separate form the financing decision (how much should be invested or borrowed at the risk-free rate)


what is market portfolio

a portfolio that contains all risky securities in the market
- theoretically should contain all risky assets worldwide, including stocks, bonds, options, futures, gold, real estate etc. in their proper proportions
- such a portfolio would be completely diversified
- not real
- use market indexes, such as the S & P / TSX and S&P 500 used to measure its behaviour


the market portfolio is referred to as what

an equilibrium condition
because supply equals demand for all the risky securities, and we place T with M, which is not the tangent portfolio but also the market portfolio