2.1.BKM Ch 09

  1. Two vital functions of the CAPM
    • Provides a benchmark rate of return
    • Help us determine the expected return on assets that have not yet been traded
  2. 6 assumptions of the CAPM
    • There are many investors, each with small wealth compared to the total
    • All investors plan for one identical investing period
    • Investments are limited to a universe of publicly traded financial assets (stocks, bonds, risk-free)
    • Investors pay no taxes on return and no transaction costs
    • All investors are rational mean-variance optimizers
    • All investors analyze securities in the same way and share the same economic view (homogeneous expectations)
  3. Mutual fund theorem
    Under the CAPM assumptions, the passive strategy of investing in a market index portfolio is efficient
  4. Expected return-beta relationship
    • E(ri) = rf + βi[E(rM) - rf]
    • Graphically this equation represents the SML
  5. CAPM vs Capital Budgeting
    When a firms enters a new project, the CAPM can provide the required rate of return that the projects needs to yield, based on its beta, to be acceptable to its investors. This yield is also called IRR or hurdle rate.
  6. CAPM vs Index Model
    • Both model yield to the same equation
    • The only difference is that CAPM predicts expected return while the Index Model uses actual market index results
    • βi = Cov(Ri, RM) / σM2
    • Market Model: ri - E(ri) = βi[rM - E(rM)] + ei
  7. Practicability of the CAPM
    • If all α = 0, there would be no inventive to engage in security analysis
    • A security is mis-priced <=> αi ≠ 0, where αi can only be revealed by superior security analysis
  8. The Zero-Beta Model
    • Any PF that is a combination of two frontier PF is itself on the efficient frontier
    • E(ri) can be expressed as an exact linear function of E(rP) and E(rQ), where P and Q are two efficient-frontier portfolio
    • Every portfolio on the efficient frontier (except global min-var) has a zero-beta portfolio on the bottom inefficient half of the frontier with which it is uncorrelated
  9. Labor Income and Nontraded Assets
    • A CAPM important departure from realism is that it ignores asset classes that are not traded:
    • Human capital
    • Privately held businesses
  10. 4 Extensions of CAPM
    • Zero-β: assumes unrestricted borrowing & lending is not possible → investors select a combination of mkt PF and a zero-β PF, where E(z) > rf
    • Labor-income & non-traded assets: includes those factors
    • Lifetime consumption and Intertemporal CAPM: may be more realistic to consider lifetime consumption plan where rf, E(rM), and σM change
    • Consumption-based CAPM: E(Ri) = βiCRPC where PC is a consumption-tracking portfolio (disadv: consumption growth figures are published infrequently)
  11. Liquidity
    • Ease and speed with which an asset can be sold at a fair market value. It reflects (a) the cost of engaging a transaction, (b) the impact that your own selling has on the price, and (c) the immediacy or speed at which the transaction can occur.
    • Less liquid assets tend to generate substantially higher returns
    • Liquidity is an important characteristic that affects stocks' value
  12. 3 issues when testing CAPM
    • Uses mkt PF which can't be reproduced
    • Stated in E(r), but we only observe actual return
    • Since uses E(r), we can't test linear relationship
  13. 3 add'l liquidity β that can be added to CAPM
    • Sensitivity of security's illiquidity to mkt illiquidity
    • Sensitivity of stock's return to mkt illiquidity
    • Sensitivity of security's illiquidity to mkt return
Card Set
2.1.BKM Ch 09