E435

explain why the CAPM provides a useful tool to determine the cost of capital

1. Since CAPM prices the individual asset based on the assumption that investors hold fully diversified portfolio, only systematic risk, i.e. the correlation with aggregate market, will be priced. (This tells why CAPM provides a reasonable price.) 2. Cost of capital is basically the required return from the perspective of investors. Therefore, the required return calculated based on CAPM can be used to determine the cost of capital.

6. Briefly describe the SMB ("small-minus-big") trading strategy.

A portfolio resulting from a trading strategy that each year buys a small market value portfolio and finances that position by selling short a large market value portfolio. Small stocks have historically earned higher average returns than the market portfolio

1. What is an efficient portfolio?

A portfolio that contains only systematic risk. An efficient portfolio cannot be diversified further; there is no way to reduce the volatility of the portfolio without lowering its expected return. When risk-free borrowing and lending is available, the efficient portfolio is the tangent portfolio, the portfolio with the highest Sharpe ratio in the economy.

Describe an advantage and a disadvantage of the multifactor model of risk relative to the CAPM.

A: It's much easier to identify a collection of portfolios that captures systematic risk than just a single portfolio B: Given that its difficult to estimate returns adding factors increases difficulty of estimating the model. This task is especially complex because it is unclear which economic risk the portfolios capture, so we cannot hope to come with a reasonable estimate of what the return should be based on an economic argument

Briefly explain why portfolio P is not the best risky portfolio we can combine with the risk-free asset.

Any portfolio on the curve above portfolio P can be combined with risk-free asset such that the combined portfolio has higher expected return and the same volatility as portfolio P.

What is the rationale behind the multifactor models of risk premium?

If the market portfolio is not efficient (as argued in the CAPM) we need to find an alternative method to identify an efficient portfolio Although we might not be able to identify the efficient portfolio itself, we do know some characteristics of the efficient portfolio 1. Any efficient portfolio will be well diversified 2. It is not actually necessary to identify the efficient portfolio itself... • as long as we can identify a collection of well- diversified portfolios from which an efficient portfolio can be constructed we can use the collection itself to measure risk we can construct an efficient portfolio from a collection of well-diversified portfolios of factors

3. What is the required return of a security?

Is the expected return that is necessary to compensate for the risk investment i will contribute to portfolio P If i's expected return exceeds the required return, then adding more of it would improve the performance of the portfolio

5. What does it mean to have short position in a security? And a long position?

Negative investment in a security The investor borrows today a security and returns Short selling can be profitable if the investor expects the price of the security to decline in the future or if invest in a security with even higher return

In a competitive market, do you consider the volatility of a stock an appropriate measure of risk? Why?

No, volatility includes firm specific risk, which can be eliminated by diversification. Therefore, the systematic risk of a stock is a more appropriate measure.

5. What does it mean to have short position in a security? And a long position? (long)

Positive investment in a security The holder of the position owns the security and will profit if the price of the security goes up

Suppose now that you form an equally weighted portfolio with n stocks. Denoting by Rp the returns of the portfolio, one can show that its variance is given by: V ar(Rp) = 1/n (Average variance of individual stocks) + (1 − 1/n) (Average covariance between stocks

The average variance captures the firm-specific risk while the average co-variance captures the market risk of the stocks. The volitility of the portfolio is affected by bothe the idiosyncratic and the systematic risk of the stocks

4. What are the alpha and the beta of a security and what do they measure? (alpha)

The difference between a stock's expected return and its required return according to the security market line. It measures the historical performance of the security relative to the expected return predicted by the security market line

2. What is the Sharpe ratio of a portfolio and what does it measure?

The excess return of an asset divided by the volatility of the return of the asset; a measure of the reward per unit risk.

4. What are the alpha and the beta of a security and what do they measure? (beta)

The expected percent change in the excess return of a security for a 1% change in the excess return of the market (or other benchmark) portfolio. Measures sensitivity of investment i to the fluctuations of the portfolio P

9. What is the interest rate tax shield?

The reduction in taxes paid due to the tax deductibility of interest payments.

7. What is the capital structure of a firm?

The relative proportions of debt, equity, and other securities that a firm has outstanding.

According to the CAPM what should be the weights that the different existing risky securities should have in your portfolio?

The weights should be the same with market portfolio.

Briefly describe why do you think there is no clear relationship between volatility and average return for individual stocks?

Volatility measures both firm-specific risk and systematic risk. Expected return only correlates with systematic risk and not firm specific risk.

10. Briefly describe one indirect cost of financial distress.

When a firm has difficulty meeting its debt obligations Loss of Suppliers: suppliers may also be unwilling to provide a firm with inventory if they fear they will not be paid

What is the theoretical justification for the CAPM?

i. Investors can buy and sell all securities at competitive market prices (without taxes or transaction costs) and can borrow and lend at the risk-free rate. ii. Investors hold only effcient portfolios of traded securities. iii. Investors have homogenous expectations regarding the volatilities, correlations, and expected returns of securities.

Empirical evidence shows the presence of "size effects": Small market capitalization stocks have historically earned higher average returns than the return suggested by the CAPM. How can this result be interpreted?

indicating that the market portfolio may not be efficient

8. How is the value of equity computed using the market value balance sheet?

under MM-Prop I, because investors can buy or sell securities on their own, no value is created when a firm buys or sells securities for them So, The total value of all securities issued by the firm must equal the total value of the firm's assets: (Market value of equity) = (market value of assets) - (market value of debt and other assets)

According to the CAPM what is the risk premium of a security?

β · (E [RM] − Rf ) A portfolio is efficient if an only if the expected return of every available unit equals its required return: rieff= rf+ β · (E [RM] − Rf ) It states that we can determine the appropriate risk premium for an investment from its beta with the efficient portfolio