Topic 2 - corporate finance

what are the two essential characteristics of a risk-free asset?

a risk-free asset has zero standard deviation and zero correlation with all other risky assets

what is the capital market line?

shows the best possible combination of the risk-free asset to market portfolio - all efficient portfolios lie on the CML

what is the capital allocation line?

represents the risk-return combinations available to an investor by varying the allocation between a risk-free asset and a risky portfolio

what does the slope of a CAL represent?

the Sharpe ratio, which is the extra return an investor earns per unit of additional risk

what is the market portfolio?

a bundle of investments that include every type of asset available in the investment universe, with each asset weighted in proportion to its total presence in the market

is the market portfolio diversified or no?

it is completely diversified and is subject only to systematic risk

what is capital market theory?

builds on portfolio theory and develops a model for pricing all risky assets

what are the assumptions of capital market theory?

• Investors can borrow or lend at the risk-free rate of return

• all investors have homogenous expectations

• there is no inflation or change in interest rates

• all investors have the same one-period horzion

• there are no taxes or transaction costs involved

what is the market equilibrium?

a state where no investor wants to change their portfolio, implying everyone holds the same optimal risky portfolio (The market portfolio)

describe markowitz vs sharpe?

simplifies Markowitz by connecting portfolios to a single risk factor and using beta as the relevant measure of risk