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Level 118

Capital Asset Pricing & Arbitrage Pricing Theory


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Capital Asset Pricing Model (CAPM)
The equation of the SML showing the relationship between expected return and beta.
Market Portfolio (M)
The portfolio for which each security is held in proportion to its total market value
Mutual Fund Theorem
The passive strategy of investing in a market index portfolio is efficient. A passive investor may view the market index as a reasonable first approximation of an efficient risky portfolio
Expected Return (mean return) beta relationship
Implication of the CAPM that security risk premiums (expected excess returns) will be proportional to beta
Security market line (SML)
a graphical representation of the CAPM with beta on the x-axis and expected return on the y-axis; slope of the line is the market risk premium (Rm - Rf)
Alpha
The difference between the fair and actually expected rates of return on a stock
Security characteristic line (SCL)
a plot of the excess return of a security on the excess return of the market, where Jensen's Alpha is the y-intercept and β is the slope
Multifactor Models
Models of security returns that respond to several systematic factors
Fama & French's Model
They say that the size of the company and the ratio of its market to book value were more useful in predicting future returns than beta
Arbitrage
Creation of riskless profits made possible by relative mispricing among securities
Arbitrage Pricing Theory (APT)
A theory of risk-return relationships derived from no-arbitrage considerations in large capital markets
Well-Diversified Portfolio
A portfolio sufficiently diversified that nonsystematic risk is small
Arbitrage Portfolio
A zero-net-investment, risk-free portfolio with a positive return
Factor Portfolio
A well-diversified portfolio constructed to have a beta of 1 on one factor and a beta of zero on any other factor
Nonsystemic Risk
Risk that is unique to a certain asset or company
CAPM Model Assumption
Basic assumption is that individuals are all alike except for wealth and risk tolerance