High-quality past paper questions and answers for the ECN226 Capital Markets 1 module for the Queen Mary University of London (QMUL) Economics Course. Each question is reproduced and high-quality full-mark scores are written up clearly for each one. Great for preparing for exams, studying and solid...
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ECN226 Capital Markets 1 – 2013
Questions and Answers
Question 1
a) An abnormal return is the difference between the actual return of a security and the expected
return. The alpha is the difference between the ‘fair’ and the actual expected rate of return. This
refers to the idea that markets are efficient, and therefore there is no way to systematically earn
returns that exceed the broad market as a whole.
The Security Market Line is the graphical representation of the return-beta relationship. It shows the
“fair” required rate of return necessary to compensate for the risk and time value of money. An
investment with a positive alpha lies above the SML line. It has a greater return, or a lower standard
deviation than the combination which is considered “fair”.
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b) The simplifying assumptions that lead to the basic version of the Capital Asset Pricing Model
(CAPM) are as follows. The CAPM derives the general equilibrium solution under the assumption
that investors are mean-variance optimizers and that markets are “perfect”.
The assumptions related to “perfect” market behavior are:
1) There is perfect competition in the capital market. This implies that the assumptions which
lead to a perfectly competitive market hold – in that there are many small investors which
are unable to impact market prices. Investors are therefore price-takers.
2) Investments are limited to a universe of publicly traded financial assets, such that there is no
investment in non-traded assets (such as private enterprises). Further, it assumes that
investor may always borrow or lend any amount at a fixed risk-free rate.
3) Investors pay no taxes on returns and there are no transaction costs.
4) The market is frictionless and there is perfect information (such that all investors know the
price of all available assets at all times).
The assumptions related to investors are:
1) The investment horizon is of a single-period (i.e. they are short-sighted and do not care
about anything after the single period).
2) All investors are rational mean-variance optimizers (they all use the Markowitz portfolio
selection model).
3) All investors have homogenous expectations or beliefs. All investors analyse securities in the
same way and share the same economic view of the world.
The results of the CAPM model are that:
1) Every investor holds a portfolio of risky assets in proportions that duplicate representation
of the assets in the market portfolio.
2) The market portfolio lies on the efficient frontier and coincides with the optimal risky
portfolio.
3) The equilibrium risk premium on the market portfolio is proportional to the risk of the
market portfolio and the degree of risk aversion of the representative investor. This is
summarised in the equation E[rm] – rf = Aσ2.
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