FINA Note 2: Capital Asset Pricing model CAPM

-personnel change in Apple may have a negative impact on share price of Apple, but have no impact on share price of Ford. -However, both Apple and Ford could be affected by the condition of general economy.

Diversification ex

b. 5%

1. Suppose the risk-free return is about 5%, and the expected market return is 12%. According to the capital asset pricing model, the expected return of a stock with beta of 0 is a. 0 b. 5% c. 12% d. 17% e. None of the above choices is correct.

-when you include additional securities in your portfolio, e.g.Ford and Apple - FIRM specific Influences on the two stocks differ, should reduce portfolio risk -There is no change on the systematic risk of your portfolio.

Diversification

•Gives precise prediction of the relationship between the risk of an asset and its expected return. -It provides a benchmark rate of return for evaluating possible investments.

Capital Asset Pricing Model (CAPM)

the expected return of a portfolio of securities is the weighted average of these securities' returns the beta of the portfolio is the weighted average of these securities' betas:

Expected Return-Beta Relationship for Portfolio

by standard deviation.

How does CML measure risk?

Beta

How does SML measure risk for individual assets?

Risk that comes from the general economy such as the business cycle, inflation, interest rates, and exchange rates

Market/Systematic risk

graphs the risk premiums of MARKET portfolio

What does the CML graph

the SML has much general applications than the CML

Why is the SML more broadly used?

is a function of the INDIVIDUAL security's contribution to the risk of the market portfolio. Or say, it is a function of the covariance of returns with the assets that make up the market portfolio.

•The risk premium on individual securities

d. The CAPM assumes that expected return of a financial asset depends on its volatility.

1. Which of the following statement is NOT correct regarding the CAPM? a. The CAPM fails in empirical tests. b. The CAPM is based on many assumptions, some of which are unrealistic. c. The CAPM is still frequently used in the real world. d. The CAPM assumes that expected return of a financial asset depends on its volatility. e. All of the above choices are correct.

c. fairly priced.

1. Your opinion is that security C has an expected rate of return of 0.11. It has a beta of 1.1. The risk-free rate is 0.04 and the market expected rate of return is 0.10. According to the Capital Asset Pricing Model, this security is a. underpriced. b. overpriced due to the alpha of 0.4%. c. fairly priced. d. overpriced due to the alpha of 0.6%. e. cannot be determined from data provided.

risk that affects only a specific firm such as Apple's success in the design and production of new iPad and iPhone, personnel changes (e.g.Steve Jobs passed away), etc

Firm-specific/unsystematic risk

-Individual investors are price takers -Investors are rational mean-variance optimizers -There are homogeneous expectations -Single-period investment horizon -Investments are limited to traded financial assets -All investors have the access to all the financial assets -No taxes and transaction costs -Information is costless and available to all investors

Capital Asset Pricing Model Assumptions

•fails empirical tests: -The data reject the hypothesis that alpha values are uniformly zero at acceptable levels of significance. -On average, LOW-beta securities have POSITIVE alphas and -HIGH-beta securities have NEGATIVE alphas.

Cons For Capital Asset Pricing Model (CAPM)

If a stock is UNDERPRICED, it will provide an expected return in excess of the fair return predicted by the SML. Underpriced stocks therefore plot above the SML.

How does the Positive-Alpha Stock work?

considered the best available description of security pricing and is widely accepted. Explicitly or implicitly, practitioners do use

Is Capital Asset Pricing Model (CAPM) practical?

⇒ P_1=31.63 (D_1+P_1-P_0)/P_0 =(2+P_1-30)/30=E(r) 3%+1.3∗(10%-3%)=12.1%=P_1

PRACTICE: •E(rM) = 10%, rf = 3% 1)Current price (P0) is $30 and it pays $2 dividend per share at the end of the year. Given β = 1.3, what is the price we expect to sell the share at the end of the year?

Beta=1 since it has the same return as the market.

PRACTICE: •E(rM) = 10%, rf = 3% 2)Suppose a stock that has an expected return of 10%. What is its beta?

beta = -0.143 2%=3%+beta(10%-3%),

PRACTICE: •E(rM) = 10%, rf = 3% 3)Suppose a stock that has an expected return of 2%. What is its beta?

is the best simple model to explain returns on risky assets. -Without security analysis, α is assumed to be zero. -Positive and negative alphas are revealed only by superior security analysis.

Pros for Capital Asset Pricing Model (CAPM)

•All investors will hold the SAME portfolio for RISKY assets - market portfolio, which contains all securities and the proportion of each security is its market value as a percentage of total market value.

Resulting Equilibrium Conditions

False. Beta= 0 implies E(r) = rf , not zero.

True or False Q1: a) Stocks with a beta of zero offer an expected rate of return of zero.

False. Investors require a risk premium only for bearing systematic risk. Total volatility includes diversifiable risk.

True or False Q2: b) The CAPM implies that investors require a higher return to hold highly volatile securities.

False. Your portfolio should be invested 60% in the market portfolio and 40% in T-bills.

True or False Q3: c) You can construct a portfolio with beta of 0.60 by investing 0.6 of the investment budget in T-bills and the remainder in the market portfolio.

• to make a guess to the expected return on assets that have not yet been traded in the marketplace.

What does CAPM help with

a benchmark for the evaluation of investment performance.

What does Positive-Alpha Stock: Security market line provide

on the average risk aversion of all market participants:

What does the Risk premium on the market depend on?

graphs INDIVIDUAL asset or portfolio risk premiums.

What does the SML graph (Security Market Line)

-The Fed may announce to raise interest rate tomorrow. Standard & Poor's may downgrade the U.S. credit rating from AA+ to AA.

•Which of the followings represent systematic risk? -The Fed may announce to raise interest rate tomorrow. -Tim Cook may resign from the CEO position of Apple next month. -Ford may recall all of its 2015 Fusion due to safety problem. -Standard & Poor's may downgrade the U.S. credit rating from AA+ to AA.