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Cards In This Set
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 One way to think of investment assets is that each asset contains many different _____ _____, and exposure to these ______ _____ earn a risk premium. |
 Factor Risks |
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Examples of underlying ______ of investment assets include the market (known as beta in risk models), interest rates, investing styles (E.g. value/growth, momentum, high volatility), or inflation.
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Factors
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______ _____ is based on an analysis of factor risks. Each factor risk represents exposures to bad times, hence risk premiums are provided for taking on the factor risk.
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Factor Theory
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Three Primary Principles of Factor theory are: - Factors are important, not _____. It's important to understand the underlying risk factors of an _____- _____ represent bundles of factors. For example, corporate bonds may contain equity risk, interest rate risk, volatility risk, and default risk. - Investors differ in their ______ risk exposures, so will take on different exposures to risk factors.
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Assets, assetAssetsoptimal
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The ______ _______ ______ ______ measures the covariance of an asset with the market portfolio (E.g. S&P 500 or DJIA) in a measure called Beta (the risk premium is determined only by the asset's Beta). This model assumes that the only factor is the market portfolio.
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Capital asset pricing model (CAPM)
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What is the mathematical formula for the Capital Asset Pricing Model (CAPM)?
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E(Ri) − Rf= 𝜶𝒊 + 𝜷𝒊 ∗ [E(R𝑴) − Rf ]
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What is the mathematical formula for Beta?
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Cov(Ri, Rm) / var(Rm) Beta is the covariance of the individual stock's return with the market (co-movement with the market) divided by the variance of the market returns.
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Six takeaways from the CAPM: Takeaway #1: Hold the _____, not the individual _____.
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Hold the factor, not the asset. An investor can eliminate idiosyncratic risk (firm-specific) by diversifying. Systematic risk will still exist, even after diversifying.
CAPM says that diversifying improves the risk-return trade off of a portfolio, which improves the Sharpe ratio as well. |
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The mean-variance _______ _________ is a graph that shows how investors can optimally hold the risky asset and the risk-free asset in their portfolio. The risky asset and risk-free asset (risk-return) tradeoff is represented by the _______ allocation line.
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 mean-variance efficient frontiercapital allocation lineThe Tangency Portfolio is the mean-variance efficient market portfolio, which represents the maximum Sharpe ratio (best risk adjusted return) |
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Six takeaways from the CAPM - Takeaway #2:Every investor holds the same mean-variance efficient portfolio, but the proportion of the risk-asset held differs between investors. In other words, each investor has their own _______ factor risk exposures.
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optimal
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Six takeaways from the CAPM - Takeaway #3:The average investor is ______ invested in the market. The average investor's risk ______ is the risk aversion of the market, so they hold the risky mean variance efficient market portfolio.
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100% invested. risk aversion
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Six takeaways from the CAPM - Takeaway #4:Exposure to factor risk must be rewarded. The risk premium is proportional to the market _______. As market _______ increases, the risk premium also increases.
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variance
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Six takeaways from the CAPM - Takeaway #5:Risk is measured as _______ exposure. The CAPM implies that securities with higher ______ should have higher average excess returns (and lower diversification benefits). Also, average returns are linear in the ______.Low _____ assets do comparatively well when markets perform poorly.
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beta betas betas beta E(rit) –rft= βi[E(rMt) –rft].
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Six takeaways from the CAPM - Takeaway #6:Valuable assets have ____ risk premiums.
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low This is because the market portfolio is the risk factor and bad times result in low market returns. Low beta assets will have positive payoffs compared to the market during bad times, which makes them valuable to investors.
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7 Shortcoming of the CAPM - Assumption #1:Investors only have _______ wealth
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financial Investors have many factors that contribute to wealth, such as human capital
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