Topic 3 - corporate finance

what is beta?

a measure of the systematic risk associated with a particular asset

what is the security market line?

the SML shows the relationship between beta and expected return

what is CAPM?

an expansion of portfolio theory which allows for the pricing of all risky assets

what does CAPM provided

a systematic framework for pricing risky assets and understanding the trade-off between risk and return

describe unsystematic risk in CAPM?

unsystematic risk is irrelevant in determining asset prices because it can be diversified away

in CAPM what determines an assets expected return?

its level of systematic risk (Beta)

what does CAPM say about expected returns?

it is a theory to show when expected returns reflect the assets systematic risk in equilibrium

what are the assumptions of CAPM?

• investors are rational and want to maximise utility

• investors hold diversified portfolios, eliminating all unsystematic risk

what are the problems with CAPM?

practical application requires careful consideration of real world complexities and limitations due to systematic risk not being eliminated through diversification

what is the key idea of the Zero-beta CAPM?

Black (1972) revealed that CAPM does not require the existence of a risk-free asset, instead the model uses a zero-beta portfolio

what is a zero-beta portfolio?

a portfolio if risky assets with zero covariance with the market portfolio

what stays the same in zero-beta CAPM?

that beta is still the correct measure of systematic risk and the model still has a linear specification

why was zero-beta CAPM developed?

to address the unrealistic CAPM assumption that investors can borrow/lend at a risk-free rate

what is a negative-beta asset?

an asset that acts as ‘recession insurance’ because it performs well when the market crashes

why can a negative-beta asset have returns below the risk free rate?

investors are willing to accept lower returns because the asset provided valuable diversification benefits during market crashes

what is APT?

a multi-factor model developed by Ross (1976) as an alternative for CAPM for asset pricing

how is APT different from CAPM?

it does not rely on one efficient market portfolio but instead assumes that expected returns of an asset is dependent upon how that asset reacts to a set of macroeconomic factors

what are the weaknesses of APT?

is ill-defined in terms of both the type and the number of variables relevant to explaining equity share returns