WEEK 8 - CAPM Flashcards
How do we calculate the required return on the share of a company?
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
How do we find the Risk Premium?
- 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)
What are the Objections to looking at previous returns in finding the risk premium?
- Bold assumption that the extra returns received in the past reflect their required returns
- Investors in the past mightβve gotten lucky
- Donβt know how many years to look at
- Debate on using rate of return on Govt bonds or treasury bills in finding the risk-free
What is the debate regarding finding the risk-free rate of return?
- 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)
What is the generally accepted market premium rate?
3-5%
How do we find the market premium?
Equity% - Rf
What is the measure of risk on financial securities in the UK from 1900-2016?
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
What does the Capital market line look like considering differing portfolios?
SEE GRAPH IN NOTES
What does the Hypothetical Capital Market line look like?
SEE GRAPH IN NOTES
How do we calculate the Expected Return?
E(Rp) = ππΉRf + πME(Rm)
Where:
E - expectation operator,
π
π β return on portfolio P,
ππΉ β share of risk-free asset in portfolio,
π
πΉ β return on the risk free asset,
ππ β share of market portfolio in portfolio,
π
π β return on the market portfolio
What is the Capital Market Line calculation?
πΈ(π π )=πΈ(π πΉ )+((πΈ(π π )βπ πΉ))/ππ to the power of ππ
-How much extra return do I get if I increase risk by 1
SEE NOTES FOR BETTER VIEW
(SEE EXAMPLE IN NOTES)
How do we identify if a share has a systematic or unsystematic risk?
SEE GRAPH IN NOTES
What does the CAPM define Systematic risk as?
Beta
Where previously it was St Dev
What does the Beta (Ξ²) measure?
Measures the Covariance between the returns on a particular share with the returns on the market as a whole
What is one of the assumptions in the CAPM model?
All investors are assumed to hold the market portfolio
What is the implication of this assumption to the CAPM model?
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
What is the formula to calculate the Beta of an asset?
Bj = Cov (Ri,Rm)/ π2M (2 is to the power of)
Where: - Ξ²= beta of asset, j; - Cov(Rj, RM ): Covariance of Asset J with the market portfolio π2M: Variance of the market portfolio
What does the beta explain?
Ξ² = 1 β 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 < Ξ² < 1 β 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.
Ξ² > 1 β A 1 per cent change in market index return generally leads to a greater return than 1 per cent on a specific companyβs share.
How do we calculate the Security Market line (SML)?
Rj = RF + Ξ²(RM β 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 π½=1.2
(π
πΉ=6% and ππ£πππππ πππ π ππππππ’π=5%):
Rj = 6% + 1.2(5% )=12%
What does the Hypothetical Security Market line look like?
See graph in notes
What cause a shift in the SML?
Changes to the risk free rate
How do you calculate the expected return using the beta?
Ri + Ξ² (Rm - Rf)
EXAMPLE OF CALCULATING THE SECURITY MARKET LINE
SEE IN NOTES
How do we calculate the characteristic line?
Rj = Ξ± + Ξ²j Γ RM + e
Where:
Rj = rate of return on the jth share;
RM = rate of return on the market index portfolio;
Ξ± = 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);
Ξ²j = the beta of security j
