Investment Theory - Note 7

What does CAPM stand for?

Capital Asset Pricing Model.

What is the main purpose of the CAPM?

To relate systematic risk to equilibrium expected returns.

What is a price-taking investor?

An investor whose individual trades cannot affect market prices.

What holding-period assumption does the CAPM make?

All investors use the same single investment horizon.

What does CAPM assume about taxes and transaction costs?

There are none.

What borrowing and lending assumption does CAPM make?

Investors can borrow and lend freely at the risk-free rate.

What are homogeneous expectations?

Investors share the same information, analysis, and expectations.

How do rational CAPM investors choose portfolios?

They optimize expected return and variance.

What is the market portfolio (M)?

All market assets held in proportion to their market values.

Where is the market portfolio under CAPM?

On the efficient frontier, at the optimal risky portfolio.

What is the mutual fund theorem?

All investors desire the same risky market portfolio.

How do CAPM investors differ in their final portfolios?

They choose different mixes of the market portfolio and risk-free assets.

What determines the market portfolio's equilibrium risk premium?

Market risk and investors' typical degree of risk aversion.

What happens if the market risk premium is excessively high?

Demand raises asset prices, reducing expected risk premiums.

What is the CAPM expected return formula?

E(ri) = rf + βi × [E(rM) − rf].

What does rf represent in the CAPM formula?

The risk-free rate.

What does βi represent?

Sensitivity to systematic market risk.

What does E(rM) − rf represent?

The market risk premium.

What risk is rewarded by the CAPM?

Systematic risk, measured by beta.

Why is firm-specific risk not rewarded in CAPM?

It can be eliminated through diversification.

What is the CAPM risk premium of a stock?

βi × [E(rM) − rf].

What does beta greater than 1 indicate?

Greater sensitivity to market movements than the market portfolio.

What does beta equal to 1 indicate?

Market-level systematic risk.

What is the CAPM expected return when beta is zero?

The risk-free rate.

If beta doubles, what happens to the CAPM risk premium?

It doubles, holding the market risk premium constant.

rf = 3%, E(rM) = 11%, β = 1.5. Required return?

15%.

rf = 4%, E(rM) = 10%, β = 0.5. Required return?

7%.

What does SML stand for?

Security Market Line.

What does the Security Market Line show?

Expected or required return as a function of beta.

What is the SML's horizontal-axis risk measure?

Beta.

What is the slope of the SML?

The market risk premium.

What is the intercept of the SML?

The risk-free rate.

Where are fairly priced securities under CAPM?

On the Security Market Line.

What does a stock above the SML indicate?

Positive alpha and potential underpricing.

What does a stock below the SML indicate?

Negative alpha and potential overpricing.

What is CAPM alpha?

Expected return minus CAPM-required return.

What is the alpha formula for a stock?

α = E(ri) − [rf + βi(E(rM) − rf)].

Expected return 12%, CAPM-required return 10%: alpha?

+2%.

What does CML use to measure risk?

Standard deviation of efficient portfolio returns.

What does SML use to measure risk?

Beta, reflecting systematic risk.

What types of portfolios does the CML describe?

Efficient combinations of the market portfolio and risk-free asset.

What assets can the SML evaluate?

Individual securities as well as portfolios.

What is a practical limitation of the CAPM market portfolio?

The true portfolio of all assets is difficult to observe.

Why are market indexes used in testing CAPM?

They serve as observable proxies for the market portfolio.

What are the CAPM's two central predictions?

An efficient market portfolio and the expected return-beta relationship.

What is the single-index excess-return model?

Ri = αi + βi × RM + ei.

What does Ri represent in the index model?

The security's excess return over the risk-free rate.

What does RM represent in the index model?

The market index's excess return over the risk-free rate.

What is beta in the index regression?

The slope measuring market sensitivity.

What is alpha in the index regression?

The intercept not explained by market excess returns.

What is a regression residual (ei)?

Actual excess return minus the model-predicted excess return.

What alpha does CAPM predict for fairly priced assets?

Zero.

Why can a nonzero estimated alpha be difficult to interpret?

It may reflect mispricing, model failure, or a poor market proxy.

What does regression R-squared measure?

The share of return variance explained by the market factor.

In Note 07, what is Google's approximate regression R²?

0.374, meaning about 37.4% is explained by the index.

If R² = 37.42%, what share is unexplained by the market index?

62.58%.

What does the regression standard error measure here?

The standard deviation of firm-specific residuals.

Why use a multifactor model instead of one market index?

Systematic risk can arise from multiple economy-wide factors.

Give three possible systematic economic factors.

Interest rates, inflation, and business-cycle conditions.

What is a two-factor index model?

Ri = αi + βi1×R1 + βi2×R2 + ei.

What does each factor beta measure?

Sensitivity to that factor's excess return.

What are the three Fama-French factors?

Market excess return, SMB, and HML.

What does SMB stand for?

Small Minus Big.

What does the SMB factor measure?

The return difference between small and large firms.

What does HML stand for?

High Minus Low.

What does the HML factor measure?

The return difference between high and low book-to-market stocks.

What is the book-to-market ratio?

Book value of equity divided by market value of equity.

Why were size and value factors added to the market factor?

Small and high book-to-market stocks showed CAPM return anomalies.

What is a key advantage of multifactor models?

They explain more sources of systematic return variation.

What do macroeconomic factor models use?

Economic variables representing systematic return risks.

Which inflation measure appears in the macroeconomic factor discussion?

Unanticipated inflation.

Do multifactor models generally improve fit over the single-index model?

Yes, as described in the Note 07 empirical discussion.

What is arbitrage?

Exploiting relative mispricing to seek riskless profit.

How can arbitrage exploit identical assets priced differently?

Buy the cheaper position and sell the more expensive one.

What tends to happen when arbitrageurs exploit mispricing?

Prices move toward alignment and the opportunity disappears.

Who developed the Arbitrage Pricing Theory?

Stephen Ross (1976).

What is the central assumption behind APT?

Well-functioning markets eliminate riskless arbitrage opportunities.

What is a key distinction between CAPM and APT?

CAPM uses market equilibrium; APT relies on no-arbitrage relationships.

What portfolios does the basic APT relation apply to directly?

Well-diversified portfolios.

Does no-arbitrage alone force every individual security onto the SML?

No. The relation need not hold exactly for every individual asset.

Can APT use more than one systematic risk factor?

Yes. APT can be multifactor.

What is the general idea of multifactor APT pricing?

Expected return compensates for exposure to multiple priced factors.