Topic 7 Capital Asset Pricing Model Flashcards
What is the dominance principle?
Portfolio A is preferred or dominates portfolio B if:
* Expected return of portfolio a > expected return of portfolio b
* Standard deviation of portfolio a < standard deviation of portfolio b
What is a feasible portfolio/opportunity set of risky portfolios?
The set of all return and risk outcomes that can be achieved by combinations of stocks in all possible ways. Each point within the opportunity set represents a possible level of risk and return than an investor can achieve.
What is the minimum variance frontier?
The subset of feasible portfolios with the lowest risk at each level of expected return are known as minimum variance portfolios and form the minimum variance frontier
What is the efficient frontier?
The subset of minimum variance portfolios with the highest expected returns at each level of risk are known as efficient portfolios and form the efficient frontier.
*One way to look at it is that the assets on the efficient frontier would have dominance over the investments that aren’t, due to same Standard deviation but higher expected return
How do we determine the portfolio chosen by an individual investor?
a. Those who are more risk-averse will choose portfolios close to point G – these portfolios have less risk and lower returns
b. Those who are less risk-averse will choose portfolios further to the right on the efficient frontier – these portfolios offer higher expected returns but carry greater risk
What does the introduction of a risk free asset do?
The introduction of a risk-free asset (sigma = 0) expands the risk-return opportunities available for investment. New sets of feasible portfolios now exist. Each of the new sets of feasible portfolios is represented by a straight line from the risk-free asset to a portfolio on the efficient frontier. The position of each portfolio on these lines depends on the weighting of the risk-free asset and the risky asset in the portfolio.
How to find the highest possible expected return for any level of risk?
find the portfolio that generates the steepest possible line when combined with the risk-free asset. Draw a line from zero variance point (risk free rate) to various point on the frontier until you get the best combination of risk free to risk averse investments. Move up along the efficient frontier until you get the best return for a givens standard deviation (tangency portfolio –> maximum possible reward per unit of risk)
What is the sharpe ratio?
Reward to risk ratio:
(expected return of asset - expected return of risk free assets)/standard deviation of the asset
What is the portfolio with the highest sharpe ratio?
the portfolio where the line with the risk-free investment is tangential to the efficient frontier of risky investments
What is the optimal risky portfolio?
Optimal Risky Portfolio – the portfolio that is generated by this tangent line is known as the optimal risky portfolio. It is the market portfolio, and hence its level of risk and return are equal to those of the market overall.
How is the capital market line created?
The optimal risky portfolio that all investors will hold is a theoretical market-valued weighted portfolio of all available risky assets.
The optimal risky portfolio is then combined with the lending/borrowing at the rf to obtain an exposure that best suits the investor’s preferences.
What is the principle of no-arbitrage?
Principle of no-arbitrage: when one security has a higher return than another, more people will buy the security which pushes up its’ price and lowers its expected return. Contrarily, the security that has a lower return would result in a lower price and higher expected return. This allows it to return to equilibrium.
Reward to risk are equalized by no-arbitrage – risk in the context of a well-diversified portfolio and its contribution to the portfolio and not the security itself.
What is the expected return on any investment?
CAPM states that the expected return on any investment is equal to the risk-free rate of return plus a risk premium proportional to the amount of market risk in the investment.
What are the CAPM assumptions?
- Investors are (only) mean-variance optimizers with objective to maximize economic utilities
- Investors are all price taker (market is perfectly competitive)
- Investors has same investment horizon
* Arrive at the market at the same time and leave the market at the same time
* Realistically we enter and leave at different times
* We have this because we need everyone looking at the market at the same time to have the same info and tangency portfolio - Frictionless market (no taxes and transaction cost)
- Investors can borrow/lend money at the same risk-free rate
* Every bank charge a different rate - Investors have some information and beliefs about distributions of return (aka homogenous expectation)
- There exists a market portfolio consist all tradable assets
* In practice when you approximate market portfolio, it is an incomplete model
Can securities lie above or below the CAPM line in equilibrium?
No
