# WEEK 8 - CAPM Flashcards

1
Q

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

A

Ri + Rf +RP

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

Rf is the risk-free rate

2
Q

How do we find the Risk Premium?

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)
3
Q

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

A
• Bold assumption that the extra returns received in the past reflect their required returns
• Investors in the past mightβve gotten lucky
• Donβ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
4
Q

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

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)

5
Q

What is the generally accepted market premium rate?

A

3-5%

6
Q

How do we find the market premium?

A

Equity% - Rf

7
Q

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

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

8
Q

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

A

SEE GRAPH IN NOTES

9
Q

What does the Hypothetical Capital Market line look like?

A

SEE GRAPH IN NOTES

10
Q

How do we calculate the Expected Return?

A

E(Rp) = ππΉRf + πME(Rm)

Where:
E - expectation operator,
ππ β return on portfolio P,
ππΉ β share of risk-free asset in portfolio,
ππΉ β return on the risk free asset,
ππ β share of market portfolio in portfolio,
ππ β return on the market portfolio

11
Q

What is the Capital Market Line calculation?

A

πΈ(ππ )=πΈ(ππΉ )+((πΈ(ππ )βππΉ))/ππ to the power of ππ

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

SEE NOTES FOR BETTER VIEW

(SEE EXAMPLE IN NOTES)

12
Q

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

A

SEE GRAPH IN NOTES

13
Q

What does the CAPM define Systematic risk as?

A

Beta

Where previously it was St Dev

14
Q

What does the Beta (Ξ²) measure?

A

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

15
Q

What is one of the assumptions in the CAPM model?

A

All investors are assumed to hold the market portfolio

16
Q

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

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

17
Q

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

A

Bj = Cov (Ri,Rm)/ π2M (2 is to the power of)

```Where:
- Ξ²= beta of asset, j;
- Cov(Rj, RM ): Covariance of
Asset J with the market
portfolio
π2M: Variance of the market portfolio```
18
Q

What does the beta explain?

A

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 companyβs share.

19
Q

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

A

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 π½=1.2
(ππΉ=6% and ππ£πππππ πππ π ππππππ’π=5%):

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

20
Q

What does the Hypothetical Security Market line look like?

A

See graph in notes

21
Q

What cause a shift in the SML?

A

Changes to the risk free rate

22
Q

How do you calculate the expected return using the beta?

A

Ri + Ξ² (Rm - Rf)

23
Q

EXAMPLE OF CALCULATING THE SECURITY MARKET LINE

A

SEE IN NOTES

24
Q

How do we calculate the characteristic line?

A

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

25
Q

What is the slope of the characteristic line?

A

Ξ² = βRj/ βRm

26
Q

How do we calculate the regression line intercept?

A

Ξ± = (1- Ξ²j) Rf

27
Q

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

A

SEE GRAPH IN NOTES

28
Q

What does the characteristic line with unsystematic risk look like?

A

SEE GRAPH IN NOTES

29
Q

What are the applications of CAPM?

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```
30
Q

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

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
31
Q

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

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 securityβs return with a market index return

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

32
Q

What are the technical problems with the CAPM?

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
33
Q

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

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.

34
Q

What are the unrealistic assumptions of the CAPM model?

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
35
Q

Does the CAPM work in practise?

A

Not really,

Disparity between the Theoretical SML and the Early empirical SML

36
Q

What is Systematic Risk?

A
• Uncontrollable by an organisation

- Macro in nature

37
Q

What is Unsystematic Risk?

A
• Controllable by an organisation

- Micro by nature