EC230:WEEK-5 Financial Markets: Stock Market and Capital Asset Pricing Model (CAPM) and Introduction to Systemic Risk

What is a stock?

A stock, also known as equity, is a security that represents ownership of a fraction of the issuing corporation.

What are units of stock called?

Shares

What do shares entitle the owner to?

A proportion of the corporation's/bank's assets and profits equal to how much stock they own.

Where are stocks predominantly bought and sold?

On stock exchanges.

What does the Capital Asset Pricing Model (CAPM) address?

The relationship between risk and expected return of an investment.

Who developed the Capital Asset Pricing Model?

Harry Markowitz.

What are the main assumptions of the CAPM?

Investors are risk averse, care only about mean return and variance, and capital markets are perfect.

What is the CAPM formula?

E(Ri) = rf + Bi[E(Rm) - rf]

What does E(Ri) represent in the CAPM formula?

Expected Return on Investment i.

What does rf represent in the CAPM formula?

Risk-free Rate of interest.

What is Beta (β) in the context of CAPM?

A measure of the stock's risk in relation to the overall market.

What does a Beta greater than 1 indicate?

The stock is more volatile than the market.

What does a Beta less than 1 indicate?

The stock is less volatile than the benchmark market index.

What is the Beta of risk-free investments like Treasury Bills?

Zero.

What does a Beta of 1 indicate?

The stock/security price moves in line with the market.

What are Non-Systematic Risks?

Risks specific to a company or industry that can be eliminated through diversification.

What are Systematic Risks?

Risks that affect the overall stock markets and cannot be mitigated through diversification.

What is the significance of CAPM Beta?

It provides a single measure to assess the risk of a stock relative to the market.

What does a Beta value greater than 1 indicate about aggressive shares?

They tend to go up faster in a rising market and fall more in a declining market.

What does a Beta value less than 1 indicate about defensive shares?

They will generally experience smaller than average gains in a rising market and smaller than average falls in a declining market.

What is the typical range of Beta values?

Between 0 and 2.5.

What is the role of Beta in investment decisions?

It helps investors understand the volatility and risk associated with a stock compared to the market.

What does the term 'portfolio risk' refer to?

The risk associated with the combination of various investments in a portfolio.

What does the CAPM provide a methodology for?

Translating risk into estimates of expected return on equity (ROE).

What is the interpretation of a Beta coefficient of 1?

The stock's return is expected to follow the market movements.

What does a Beta coefficient greater than 1 imply about market responsiveness?

The returns from the security are more likely to respond to market movements, indicating higher volatility.

What is the impact of perfect capital markets on investor behavior?

All assets are infinitely divisible, and there are no transaction costs or taxes.

What does the CAPM model suggest about investor information?

All information is costless and available for everyone.

What does the capital asset pricing model (CAPM) describe?

The relationship between risk and expected return of an investment.

What does beta measure in the CAPM model?

Systematic risk.

What is the difference between systematic risk and systemic risk?

Systematic risk refers to non-diversifiable risk factors affecting everyone, while systemic risk pertains to the danger of the entire financial system collapsing.

What can a systemic event affect?

It can be global in reach or affect a single country.

What factors can indicate a country's susceptibility to systemic risk?

The size of the banking system, the proportion of domestic vs. foreign ownership, and how well a country is insulated.

Name one type of systemic risk identified by Allen and Carletti (2011).

Common exposure to asset price bubbles.

What is an example of endogenous systemic risk?

Risk resulting from the collective behavior of financial institutions.

What is an example of exogenous systemic risk?

Imbalances in the real economy.

What significant event in 1914 illustrated systemic risk?

The financial crisis did not occur because of World War I but in anticipation of it, leading to a loss of confidence and liquidity.

What structural weaknesses can lead to systemic risk?

Pro-cyclicality, information asymmetries, interdependence, and perverse incentives.

What are fire-sale externalities?

They occur when financial institutions sell risky assets at low prices to raise cash, leading to a vicious cycle of declining prices.

How can information asymmetry lead to bank failure?

A loss of confidence can cause counterparties to refuse transactions with a bank suspected to be in trouble.

What is interdependence in the context of systemic risk?

A financial institution can be indirectly exposed to another institution without direct dealings, which can be dangerous during crises.

What are perverse incentives in the financial system?

Banks may seek to become larger and more interconnected to increase the likelihood of receiving a bailout during a crisis.

What two principal components can systemic risk be analyzed through?

A shock affecting institutions and a transmission mechanism that multiplies the shock.

What does the term 'moral hazard' refer to in the context of systemic risk?

The risk that banks take on excessive risk because they expect to be bailed out.

What is the impact of a shock in systemic risk?

The impact can be non-linear and can change rapidly.

What is the main concern of systemic risk in financial markets?

The risk of widespread failures in the financial system due to interlinkages between financial institutions.

What is the role of authorities in managing systemic risk?

To find the appropriate risk-return combination similar to what investors do for their portfolios.

What happens when a single institution fails in a financial system?

It can quickly spread to other banks, even those that are prudently run.

What is the significance of the graph mentioned in the summary of systemic risk?

It illustrates that systemic risk tends to rise temporarily in response to major global and financial distress events.

What are the implications of interconnectedness in the financial system?

It increases the fragility of the financial system and the likelihood of a systemic crisis.