CAPM
Set of predictions concerning equilibrium expected returns on risky assets
Assumes that investors agree on a common input list from security analysis and seek mean-variance optimal portfolios
Market portfolio, M
Optimal tangency portfolio on the efficient frontier; When we aggregate the portfolios of all individual investors, lending and borrowing will cancel out because each lender has a corresponding borrower, and the value of the aggregate risky portfolio will
Mutual fund theorem
A result associated with the CAPM, asserting that investors will choose to invest their entire risky portfolio in a market-index mutual fund
Market price of risk
Market risk premium/Market variance
Reward to risk ratio for investment in the market portfolio
A measure of the extra risk investors demand to bear risk
Expected return-beta relationship
Implication of the CAPM that security risk premiums (expected excess returns) will be proportional to beta
Security market line (SML)
Graphical representation of the expected return-beta relationship of the CAPM
Graphs individual asset risk premiums as a function of asset risk. The relevant measure of risk for individual assets is the contribution of the asset to the portfolio variance,
Alpha
The difference between the fair and actually expected rates of return on a stock
Key implications of CAPM
1. The market portfolio is efficient
2. The risk premium on a risky asset is proportional to its beta
8 assumptions of CAPM
1. Individual behavior
a. Investors are rational, mean-variance optimizers
b. Their planning horizon is a single period
c. Investors have homogeneous expectations
2. Market Structure
a. All assets are publicly traded (short positions allowed), and investo
Homogeneous expectations
The assumption that all investors use the same expected returns and covariance matrix of security returns as inputs in security analysis
Zero-beta portfolio
The minimum-variance portfolio uncorrelated with a chosen efficient portfolio
Helps to explain positive alphas on low beta stocks and negative alphas on high beta stocks
Every portfolio on the efficient frontier has a companion portfolio on the bottom ine
Liquidity
The ease and speed with which an asset can be sold at fair market value
Illiquidity
The discount from fair market value a seller must accept if the asset is to be sold quickly. A perfectly liquid asset is one that would have no illiquidity discount
CAPM assumptions about security markets
They are large and investors are price takers
There are no taxes or transaction costs
All risky assets are publicly traded
Investors can borrow and lend any amount at a fixed risk free rate
According to CAPM, there is no reward for bearing firm-specific risk when (blank) is zero
Alpha
2 limitations of theoretical CAPM
1. it applies to expected returns not realized returns
2. it relies on theoretical portfolios of all assets
If the financial market is in CAPM equilibrium, the risk premium on individual security will be proportional to
The market risk premium and the beta coefficient of the security
CAPM predicts the relationship between:
a. The systematic risk and equilibrium expected return on risky assets
b. The market risk and realized holding period return on risky assets
c. The market risk and price of risky assets
A
According to CAPM, investors require a (blank) premium as compensation for (blank) risk. This magnitude of this risk premium is referred to as (blank). It is scaled/multiplied by the risk premium
Risk, market, beta
The (blank) market line graphs the expected return on efficient complete portfolios as a function of portfolio standard deviation while the (blank) market line graphs the expected return on individual assets as a function of their systematic risk
Capital, security
(blank) is the abnormal rate of return on a security in excess of what would be predicted by an equilibrium asset pricing model such as the CAPM
Alpha
Expected/forecasted return higher than required return
Positive or negative alpha?
Good or bad investment?
Above or below SML?
Positive alpha
Good investment
Above SML
Expected/forecasted return lower than required return
Positive or negative alpha?
Good or bad investment?
Above or below SML?
Negative alpha
Bad investment
Below SML
Required rate of return
Found using CAPM equation. Required return for a given level of risk