FI 4000 1st Edition Exam 2 Study Guide Capital Asset Pricing Model portfolio managers look for positive alpha stocks and portfolios for which demand will increase the price and reduce expected return alpha sell short negative alpha stocks assume alpha is zero meaning there is no reward from bearing firm specific risk only from systematic best portfolio is the one that completely eliminates nonsystematic risk an indexed portfolio that mimics the broad market systematic risk defined by Beta coefficient B which is its amount in a particular risky asset relative to that in an average risky asset asset with beta 0 5 has 1 2 as much systematic risk as average asset 2 0 has 2X as much if Beta is riskier than the market risk premium will provide higher returns ex Portfolio expected beta if invest 35 in A which has a Beta of 1 2 45 in B Beta of 0 8 and 20 in the risk free asset Bp 35 1 2 45 0 8 20 0 0 78 CAPM predicts relationship between risk and equilibrium and expected returns on risky asset assumes that markets for securities are perfectly competitive and equally profitable risky assets are in the investment universe public owned traded and that investors have homogenous expectations and are rational mean variance optimizers equilibrium in hypothetical world investors will choose to hold market portfolio will be the best attainable Capital Market Line optimal risky portfolio tangency point to the frontier all assets offer the same reward torisk ratio differing only in the amount invested in the risk free asset and will equal to the reward to risk ratio of market risk premium will be proportional to risk premium on market portfolio and the risk of the market portfolio beta coefficient and regression of security on market return representing sensitivity fluctuations must be high enough to induce investors to hold available supply but not too high where there will be excess demand or low so investors hold insufficient to absorb supply equilibrium risk premium proportional to risk of the market variance of returns as well as degree of risk aversion of average investor limitations are that relies on theoretical market portfolio includes all assets real estate foreign stocks and deals with expected as opposed to actual returns ex post 1 All investors use mean variance analysis passive 2 Apply this to the same universe of securities using the same security analysis 3 Experience identical net returns tax consequences 4 Will determine same optimal risky portfolio derive identical efficient frontiers and find same tangency portfolio for Cal from T bills to that frontier If Google represents 1 in each common risky portfolio it will be 1 of the aggregate risky portfolio Security Market Line where all assets in market plotted thus market portfolio mean beta relationship beta of security is appropriate measure of risk proportional to variance security contributes to optimal risky portfolio that graphs individual asset risk premiums as functions of asset risk whose risk is measured by the asset beta rather than standard deviation fairly priced plots provide required rate of return to compensate investors for beta risks and time value of money benchmark for evaluation of investment performance plots lie in equilibrium when CAPM holds plots determine where stock is relative to what it should be on a risk adjusted basis all stocks plotted above SML underpriced and no investors want to invest in this asset price will fall expected return all stocks plotted below SML overpriced and everyone wants to buy this asset price expected return goes down buying and selling pressure continues until the alpha of securities becomes zero Index Model used to counterbalance the drawback of using CAPM expected returns by utilizing realized returns using market index such as S P 500 Bond Value and Yields bond value present value of coupon annuity present value of par value final single amount priced net of accrued interest known as the flat price if discount coupon rate par value BV higher risk if the price of a bond goes down the discount rate goes up cash flows unaffected bond indentures bold words are fixed amounts except for floating rate bonds coupons regular interest payment debt security zero coupon highest interest rate risk face value par maturity value amount of cash flow bondholder will receive at maturity time to maturity number of years until maturity of bond the longer the greater sensitivity to price fluctuations after bonds issued bondholders may buy or sell bonds in secondary markets where prices fluctuate inversely with market interest rate short term treasury securities safest free of price risk and interest rate volatility ex Compute value of bond with 30 year maturity and par value of 1000 that pays 60 semiannual coupon payments for 40 The annual interest rate is 8 BV 40 1 1 1 04 60 0 04 1000 1 04 60 40 906 10 52 0 04 904 8 95 06 1000 convexity shape of curve illustrating relationship between prices and yields implies that an increase in the interest rate results in a price decline smaller than the price gain as a result of decrease in equal magnitude of interest rate becomes flatter at higher interest rates ex The coupon rate is 8 with a semiannual payment of 40 30 days have passed since the last coupon payment made150 days and if quoted price of the bond is 1000 what is the invoice price accrued interest annual coupon payment 2 days since last coupon days between payments invoice price 80 2 30 150 8 00 par value 1008 when bond pays coupon flat price equals invoice price at this time since accrued interest is zero yield to maturity standard measure of total average rate of return accounting for current income plus the price increase decrease over the bond s life from now to maturity because it is the compound rate of return over life of the bond assumes all bond coupons can be reinvested at that yield held to maturity the discount rate makes present value of bond payments equal to price as this goes up bond value goes down solve for interest rate by solving bond price equation given the bond price bond equivalent yields annualizes using simple interest effective annual yield accounts for compounded interest premium bonds sell above par value fall in value as reach maturity capital losses offset large coupon payments interest coupon rate and bond price par value discount bonds sell below rise in value as reach maturity capital gains offset small coupon payments interest coupon rate and bond price