Flashcards in Topic 5: Asset Pricing Models Deck (23)
How is the CAPM derived and what does it show?
- Derived using principles of diversification with simplified assumptions
- Showing the relationship between risk and
expected return of an asset
What researchers are credited with its development?
Markowitz, Sharpe, Lintner and Mossin
What are the first 3 assumptions of the CAPM?
1) Individual investors are price takers
2) Single-period investment horizon (ignoring anything that might happen afterwards)
3) Investments are limited to traded financial assets (can borrow or lend at risk-free rate)
What are the last 4 assumptions of the CAPM?
4) No taxes and transaction costs
5) Investors are rational mean-variance optimizers
6) There are homogeneous expectations
7) Information is costless and available to all investors
What is the market portfolio?
- Market portfolio contains all securities and the proportion of each security is its market value as a percentage of total market value
What does CAPM assume about risk premiums?
- assumes that appropriate risk premium on an asset will be determined by its contribution to the risk of investors’ overall portfolios
The variance of the portfolio is .......?
- The sum of all elements
What does beta measure?
- Beta measures the stock’s contribution to the variance of the market portfolio
what does the CML graph?
- CML graphs the risk premiums of efficient portfolios as a function of portfolio standard deviation
What does the SML graph?
- SML graphs individual asset risk premiums as a function of asset risk; the measure of risk for individual assets held as parts of well-diversified portfolios is the contribution of the asset to the portfolio variance (beta)
How can CAPM be used to analyse securities?
- portfolio manager will increase the weights of securities with positive alphas and decrease the weights of securities with negative alphas
How is CAPM is useful in project or asset valuation?
- useful in asset or project valuation by providing required rate of return (NPV valuation; DDM valuation)
Is the condition of zero alphas for all stocks as implied by the CAPM met?
- Not perfect but one of the best available
is CAPM testable?
- Proxies must be used for the market portfolio
Is CAPM still considered one of the best available description of security pricing and is widely accepted
Whats the difference between beta in CAPM and beta in single index model?
- They look the same, however, CAPM measures expected returns, while single index model measures real/historical returns
The CAPM states that the expected value of alpha
should be what for all securities?
The index model
holds that the realized value of alpha should
average out to _____ for a sample of historical
What does 'm' stand for in the two different models?
- In single index model, “m” stands for a market
- In CAPM, “m” stands for the whole market, which consists of all securities in the market
How can arbitrage arise?
- arises if an investor can construct a
zero investment portfolio with a sure profit
- Since no investment is required, an investor can create large positions to secure large levels of profit
Unlike CAPM, what does APT not assume?
- Single-period investment horizon
- Absence of personal taxes
- Risk-free borrowing or lending
- Mean-variance decisions
Whats the most important thing with the APT model?
- the deviations of the factors from their expected values.