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Flashcards in Investment theories Deck (11)
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1
Q

Basis of EMH (7)

A
  • price is always right
  • no bargains to be had
  • sufficient buyers and sellers in the market to ensure the price is correct
  • fund manager can not add value
  • EMH supports passive investment
  • everybody knows all information / nobody knows anything that anybody else doesn’t know
  • because information is priced into the market
2
Q

Three types of believers of the EMH

A

1) weak form believer - no benefit to be had from technical analysis (charts)
2) semi strong believer - no benefit to be had from technical or fundamental analysis (co. acc’s)
3) no benefit to be had from technical or fundamental analysis OR any information you have (everyone knows everything)

3
Q

CAPM

A
  • says that because non systematic risk (investment specific) can be eliminated through diversification it is not rewarded
  • it is the sensitivity of the security to the market that is the appropriate measure of risk (systematic/market risk)
  • CAPM provides the relationship between a securities systematic risk and its expected return
  • do that securities with higher leaflets of market risk/beta can be expected to have higher returns in a rising market
4
Q

(CAPM) what is beta?

A
  • market has a beta of 1
  • beta of an individual security reflects the extent to which a securities returns move up and down with the market

According to CAPM:

  • security with a beta of 1 will move up and down exactly with the market
  • if beta is more than 1 the this exaggerates the market movement and is more volatile than the market
  • if market goes up then security goes up by more
  • if market goes down then security goes down by more
  • know as aggressive securities
  • if beta is less than 1 then the opposite will happen
  • more stable than the market
  • know as defensive securities
5
Q

CAPM equation

A

Er = Rf + Bi(Rm-Rf)

Er = Expected return 
Rf = risk free rate of return
Bi = beta of investment
Rm = expected return is the market 

Shows expected return for a security as a combination of the risk free rate of return and compensation for holding a risky asset I.e. risk premium

6
Q

Assumptions for CAPM (7)

A
  • investors are rational and risk averse, making decisions based on risk and return alone
  • all investors have identical holding periods
  • market comprises many buyers and sellers and no individual can affect market price
  • no taxes or transaction costs
  • information is free and simultaneously available to all investors
  • all investors can borrow and lend money at the risk free rate
  • quantity of securities in the market is fixed and are all fully marketable (so liquidity is ignored)
7
Q

Limitations of CAPM (3)

A

Unrealistic assumptions:

  • assumes all investors and borrow unlimited funds at risk free rate
  • assumes no taxes or charges
  • assumes investors are rational and risk averse
  • assumes market is efficient
  • assumes all investors have access to all information
  • single factor model
  • based on historic data
  • difficultly identifying risk free rate
  • doesn’t work in the real world

1) what to use as risk feee rate!
- Finding a totally risk free rate is difficult.
- common practice to use TBills
- 91 day money market instruments issues by UK government
- they are virtually default risk free and due to their short life, interest rate and inflation risks are minimal

2) what is the market portfolio
- in theory CAPM uses all risky investments worldwide but in reality it usually uses an index from a particular country’s market eg FTSE 100 or all share
- betas on each index are significantly different
- so questionable whether indices represent the true market
- if true market is not used then correct beta for the security can not be determined

3) suitably of beta
- for CAPM to be useful the beta must be stable
- beta is calculated based on historic data and do not seem to be stable
- so questions reliability as a guide to estimating future risk
- some studies particularly in US show CAPM to be incorrect
- some show securities with low beta to return more than CAPM predicts and those with high beta to return less
-

8
Q

Criticisms of CAPM (7)

A
  • investors are rational and risk averse, making decisions based on risk and return alone
  • all investors have identical holding periods
  • market comprises many buyers and sellers and no individual can affect market price
  • no taxes or transaction costs
  • information is free and simultaneously available to all investors
  • all investors can borrow and lend money at the risk free rate
  • quantity of securities in the market is fixed and are all fully marketable (so liquidity is ignored)

ALSO:

  • single factor model
  • based on historic data
  • difficult to identify risk free rate
  • not a good indicator in practice / doesn’t work
9
Q

Why are momentum, size and value used in multi factor models? (3)

A
  • Momentum - shares of companies who have increased in price over the past 6-12 months tend to continue to outperform and this is not explained by CAPM
  • Value - undervalued companies measured by price to book tend to outperform
  • Size - small company shares tend to outperform larger companies
10
Q

Multi factor models

A

CAPM is described as a single factor model as it is only concerned with one factor:

  • the security’s sensitively to the market (as measured by beta)

Multi factor models attempt to describe security returns as a function of a number of factors.

Eg value, size, momentum

Multi factor models all differ but tend to share two main ideas:

  • investors require extra risk for taking risk
  • concerned with risk that can not be eliminated by diversification

Problems are-

  • Different betas need to be calculated for each factor
  • trouble identifying all the relevant factors
11
Q

Multi factor models

A

CAPM is described as a single factor model as it is only concerned with one factor:

  • the security’s sensitively to the market (as measured by beta)

Multi factor models attempt to describe security returns as a function of a number of factors.

Eg value, size, momentum

Multi factor models all differ but tend to share two main ideas:

  • investors require extra risk for taking risk
  • concerned with risk that can not be eliminated by diversification