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FRM - Schweser - Topic 4
The capital asset pricing model and its application to performance measurement
15
Finance
Professional
04/07/2010

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Term
What does the CML illustrate?
Definition

The CML illustrates the linear relationship between the expected return of a portfolio and its standard deviation when that portfolio consists of a combination of the market portfolio and the risk-free asset.

 

it's a line that extends from the risk free rate and is tangent to the efficient frontier (point of tangneyc is at at the market portfolio)

Term
If an investor is combining the market portfolio with the risk-free asset, then the expected return is (formula):
Definition
E(RP) = RF + [ (E(RM) - RF) / σM] σP
Term
What does the efficient frontier consist of?
Definition
it consists of all portfolios that have the minimum standard deviation of return given an expected return
Term
What does the CAPM state:
Definition
optimal portfolios are those composed from the market portfolio and the risk free asset
Term
What are the CAPM assumptions?
Definition

- Investors seek to maximise wealth

- all investors have the same time horizon

- investors are risk averse

- investors only consider the mean and standard deviation of returns (implies normal distribution)

- investors can borrow and lend at the risk free rate

- investors have the same expectations concerning returns

- no taxes or transaction costs

Term
Whats the CAPM formula?
Definition
E(Ri) = RF + [E(RM) - R(F)]ßi
Term

What are the three levels of market efficiency?

 

What level of market efficiency does the CAPM assume?

Definition

- Weak efficiency: information in past price patterns is incorporated into the current prices

 

- Semistrong efficiency: mean that all public information includign that in past price patterns is incorporated into the current prices

 

- Strong efficiency: means that all information (including private and public, is incorporated into the current prices).

 

 

CAPM assumes markets are strong efficient.

Term
What is the Treynor measure?
Definition

The Treynor measure is equal to the risk premium divided by Beta

 

= [E(RP) - RF] / ßP

Term
How do you calculate the Sharpe measure?
Definition
Sharpe measure = [E(RP) - RF) / σP ]
Term
How do you calculate the Jensen measure?
Definition

Jensen measure (or jensen's alpha) is the asset's excess return over the return predicted by the CAPM

 

Jensen's measure - E(RP) - [[RF + [E(RM) - RFP]

Term
For the three measure of performance higher means...
Definition
better (best return/risk)
Term
Whats a quick approximation for ßP?
Definition
ßP = σP / σM
Term
Define tracking error:
Definition
Tracking error is the term used to describe the standard deviation of the difference between the portfolio return and the benchmark return - usually the risk manager must keep tracking error below a certain threshold
Term
For each of the 3 measures, discuss when the situations in which their use is most appropriate...
Definition

Treynor measure is best for comparing well diversified portfolios...

 

Sharpe measure can be applied to all portfolios.

 

Jensen's alpha is the most apropriate for comparing portfolios that have the same beta.

Term

What is the Sortino ratio?

 

When in the Sortrino appropriate?

Definition

Sortino ratio is similar to the sharpe ratio except for 2 changes:

- RF is replaced by RMIN (the minimum accetable level of return)

 

- standard deviation is replaced by a type of semi-standard deviation. This measures the variability of only those returns that fall below the minimum acceptable level. The measure of risk in the Sortrino ratio is the square root of the mean squared deviation from RMIN of those observations in time periods t where RPt < RMIN, else zero.

 

Putting it all together...

 

Sontrino ratio = E(RP) - RMIN / square root of MSDMIN

 

MSDMIN = Sum (RPT - RMIN)2 / N    : only sum in cases where RPT < RMIN

 

 

It's appropriate for a case where returns are not symmetric

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