# Finance final: Capital Asset Pricing Model

 What is represented by E (Ri) Expected Return on a Risky Asset – The rate of return an investor expects to earn on an asset over time based on the asset’s risk level (this is based on systematic risk) What is represented by E (Rm) Expected Return on the Market – The average return of the stock market or the return on a stock market index What is usually used as a measure of market performance? S&P 500 Index or Wilshire 5000 Index What is represented by Rf Return on the risk-free asset – The return that an investor receives on a safe asset that is free from credit risk What do investors usually use as the risk-free rate? The rate of return on U.S. Treasury bills – because there is an underlying assumption that the U.S. government will always meet is financial obligations What is beta? Beta is a measure of an asset’s systematic risk -indicates how responsive a stock’s return is to changes in the expected return of the market What does the overall market have a beta of? 1 What does it mean if an asset has a beta greater than 1? That the asset is riskier than the market What is an example of an asset that has a beta great than 1? Technology What does it mean if an asset has a beta less than 1? That the asset is less risky than the market What are examples of an asset that has beta less than 1? Utilities (stable business) How do you calculate the market risk premium? It is the expected return of the stock market minus the risk-free rate What is the formula for the market risk premium? [ E (Rm) – Rf] What does standard deviation of a return measure? Measures the risk of an asset-how volatile What does a higher standard deviation mean?What does a lower standard deviation mean? Higher means greater riskLower means less risk What is the Capital Asset Pricing Model? (CAPM) Theory used to price risk asset-focuses on the tradeoff between the risk of an asset and the expected return associated with that asset What is the formula used for CAPM? E (Ri) = (Rf) + (Bi) [ E(Rm) – (Ef) ] What is CAPM a tool for? CAPM is a very simple yet powerful way to estimate the cost of equity, which is usually the most significant component of a company’s weighted cost of capital What is a risk premium? The amount by which an investment is expected to outperform T-bills or the average amount by which an investment has outperformed T-bills in the past. How do we calculate a risk premium? (Market Average) – (Risk free rate) = Risk premium What is a portfolio? The specific securities (stocks, bonds, mutual funds) owned by an investor How do you calculate the return on a portfolio? The return on a portfolio is calculated by multiplying the return on a specific security by the percent of the portfolio the security represents and then adding the result for each security together. What does a portfolio’s beta measure? Measures the systematic risk of the portfolio What is Alpha? Alpha relates to returned, observed performance after the fact. How do you determine alpha? Observed Return – Expected Return What does a positive alpha mean? The security outperformed the returns expected under the CAPM benchmark-good thing What does a negative alpha mean? The security underperformed the returns expected under the CAPM benchmark-bad thing CAPM formula to use is? E (Ri) = Rf + Bi * (Rm – Rf) Market Premium formula? (Rm – Rf) What is beta? Bi – measure of unsystematic risk, before the fact How do you find out alpha? Observed return of asset – Expected return of asset Unsystematic risk Firm specific risk – The risk that can be diversified away Systematic risk Market related risk as measure by Beta. Can not be diversified away.
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