WEEK 8 - CAPM Flashcards

Question 1

Q

How do we calculate the required return on the share of a company?

Answer

A

Ri + Rf +RP

Where:
Ri is the required return on share of company i

Rf is the risk-free rate

RP is the risk premium

Question 2

Q

How do we find the Risk Premium?

Answer

A

Estimate the risk premium for the averagely risky share on the stock market (Using historical returns)
Multiply this number by a risk adjustment factor for each individual share (RP = Rm-Rf)

Question 3

Q

What are the Objections to looking at previous returns in finding the risk premium?

Answer

A

Bold assumption that the extra returns received in the past reflect their required returns
Investors in the past might’ve gotten lucky
Don’t know how many years to look at
Debate on using rate of return on Govt bonds or treasury bills in finding the risk-free

Question 4

Q

What is the debate regarding finding the risk-free rate of return?

Answer

A

Debate on using rate of return on Govt bonds or treasury bills in finding the risk-free rate of return.

Generally, use Bills in SR
Use treasury bills in LR (Gilts/Bonds)

Question 5

Q

What is the generally accepted market premium rate?

Question 6

Q

How do we find the market premium?

Answer

A

Equity% - Rf

Question 7

Q

What is the measure of risk on financial securities in the UK from 1900-2016?

Answer

A

Equities 20.0% St Dev.
Gilts 13.7% St Dev.
Treasury Bills 6.4% St Dev

Where St Dev is used as measurement of risk

Question 8

Q

What does the Capital market line look like considering differing portfolios?

Answer

A

SEE GRAPH IN NOTES

Question 9

Q

What does the Hypothetical Capital Market line look like?

Answer

A

SEE GRAPH IN NOTES

Question 10

Q

How do we calculate the Expected Return?

Answer

A

E(Rp) = 𝜔𝐹Rf + 𝜔ME(Rm)

Where:
E - expectation operator,
𝑅𝑃 – return on portfolio P,
𝜔𝐹 – share of risk-free asset in portfolio,
𝑅𝐹 – return on the risk free asset,
𝜔𝑀 – share of market portfolio in portfolio,
𝑅𝑀 – return on the market portfolio

Question 11

Q

What is the Capital Market Line calculation?

Answer

A

𝐸(𝑅𝑝 )=𝐸(𝑅𝐹 )+((𝐸(𝑅𝑀 )−𝑅𝐹))/𝜎𝑀 to the power of 𝜎𝑃

-How much extra return do I get if I increase risk by 1

SEE NOTES FOR BETTER VIEW

(SEE EXAMPLE IN NOTES)

Question 12

Q

How do we identify if a share has a systematic or unsystematic risk?

Answer

A

SEE GRAPH IN NOTES

Question 13

Q

What does the CAPM define Systematic risk as?

Answer

A

Beta

Where previously it was St Dev

Question 14

Q

What does the Beta (β) measure?

Answer

A

Measures the Covariance between the returns on a particular share with the returns on the market as a whole

Question 15

Q

What is one of the assumptions in the CAPM model?

Answer

A

All investors are assumed to hold the market portfolio

Question 16

Q

What is the implication of this assumption to the CAPM model?

Answer

A

In the CAPM model, because all investors are assumed to
hold the market portfolio, an individual asset (e.g. a share) owned by an investor will have a risk that is defined as the amount of risk that it adds to the market portfolio

Question 17

Q

What is the formula to calculate the Beta of an asset?

Answer

A

Bj = Cov (Ri,Rm)/ 𝜎2M (2 is to the power of)

Where:
- β= beta of asset, j; 
- Cov(Rj, RM ): Covariance of 
  Asset J with the market 
  portfolio  
𝜎2M: Variance of the market portfolio

Question 18

Q

What does the beta explain?

Answer

A

β = 1 ⇒ A 1 per cent change in the market index return generally leads to a 1 per cent change in the return on a specific share.

0 < β < 1 ⇒ A 1 per cent change in the market index return generally leads to a less than 1 per cent change in the returns on a specific share.

β > 1 ⇒ A 1 per cent change in market index return generally leads to a greater return than 1 per cent on a specific company’s share.

Question 19

Q

How do we calculate the Security Market line (SML)?

Answer

A

Rj = RF + β(RM − RF )

Where:
- Ri - Expected Return
- Rf - Risk free rate
- (Rm - Rf) - The average risk premium for a share
(Expected return on the market minus the risk free rate)

E.g.

For a share j with 𝛽=1.2
(𝑅𝐹=6% and 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚=5%):

Rj = 6% + 1.2(5% )=12%

Question 20

Q

What does the Hypothetical Security Market line look like?

Answer

A

See graph in notes

Question 21

Q

What cause a shift in the SML?

Answer

A

Changes to the risk free rate

Question 22

Q

How do you calculate the expected return using the beta?

Answer

A

Ri + β (Rm - Rf)

Question 23

Q

EXAMPLE OF CALCULATING THE SECURITY MARKET LINE

Answer

A

SEE IN NOTES

Question 24

Q

How do we calculate the characteristic line?

Answer

A

Rj = α + βj × RM + e

Where:
Rj = rate of return on the jth share;
RM = rate of return on the market index portfolio;
α = regression line intercept; e = residual error about the regression line (in this simple case this has a value of zero because all the plot points are on a straight line);
βj = the beta of security j

Question 25

Q

What is the slope of the characteristic line?

Answer

A

β = ∆Rj/ ∆Rm

Question 26

Q

How do we calculate the regression line intercept?

Answer

A

α = (1- βj) Rf

Question 27

Q

What does the characteristic line with no unsystematic risk look like?

Answer

A

SEE GRAPH IN NOTES

Question 28

Q

What does the characteristic line with unsystematic risk look like?

Answer

A

SEE GRAPH IN NOTES

Question 29

Q

What are the applications of CAPM?

Answer

A

Investment in the financial markets
-Portfolio selection
-Mispriced shares
-Measuring portfolio performance
Calculating the required rate of return on a firm's investment projects

Question 30

Q

What are some accepted and controversial aspects of CAPM? (PART 1)

Answer

A

Shareholders demand a higher return for riskier assets
Risk-averters are wise to diversify
The risk of securities (for example shares) has two elements: (a) unsystematic risk factors specific to firms which can be diversified away; and (b) systematic risk caused by risk factors common to all firms
Investors will not be rewarded for bearing unsystematic risk

Question 31

Q

What are some accepted and controversial aspects of CAPM? (PART 2)

Answer

A

Different shares have different degrees of sensitivity to the systematic risk elements
Systematic risk is measured by beta which, in practice, is
calculated as the degree of co-movement of a security’s return with a market index return

-Beta, as calculated by examining past returns, is valid for decision making concerned about the future

Question 32

Q

What are the technical problems with the CAPM?

Answer

A

Measuring beta
Ex ante theory with ex post testing
The market portfolio is unobtainable
One-period model
Very few government securities are close to being risk free
Unrealistic assumptions

Question 33

Q

Why is measuring the beta a technical problem of the CAPM model?

Answer

A

not clear whether it is more appropriate to use daily, weekly or monthly data, or whether the observation period should be three, five or ten years.

Question 34

Q

What are the unrealistic assumptions of the CAPM model?

Answer

A

Investors are rational utility maximizers
Information is freely available
Investors can borrow and lend at the risk free-rate
Capital markets are perfectly competitive and frictionless
Securities are infinitely divisible

Question 35

Q

Does the CAPM work in practise?

Answer

A

Not really,

Disparity between the Theoretical SML and the Early empirical SML

Question 36

Q

What is Systematic Risk?

Answer

A

Uncontrollable by an organisation

- Macro in nature

Question 37

Q

What is Unsystematic Risk?

Answer

A

Controllable by an organisation

- Micro by nature

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WEEK 8 - CAPM Flashcards

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