# 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