Financial Asset Pricing Theory Quiz

CAPM is used to determine the appropriate expected return on an asset based on its risk and the market's risk premium.

The risk-free rate represents the rate of return expected from an investment with no risk of default, often approximated by government bond yields.

CAPM calculates the expected return on an asset by adding the risk-free rate to the product of its beta coefficient and the market risk premium.

The risk-free rate serves as the benchmark for the return an investor would expect from an investment with no risk of default, forming the basis for determining the risk premium in CAPM.

Beta measures an asset's sensitivity to market movements and represents the systematic risk inherent in the asset, indicating how much its returns are expected to vary with market returns.

Alpha measures the excess return of a portfolio or investment strategy compared to its expected return based on its risk exposure, indicating skill in portfolio management or market inefficiencies.

The Sharpe Ratio measures the risk-adjusted performance of an investment, portfolio, or strategy by comparing its excess return to its volatility, indicating how much excess return an investor receives per unit of risk taken.

EMH assumes that investors are rational, have access to all relevant information, and make investment decisions to maximize their utility.

Arbitrage involves exploiting price discrepancies in financial markets by simultaneously buying and selling the same asset to make risk-free profits.

The Fama-French Three-Factor Model asserts that asset returns are influenced by three factors: market risk, the size of the firm, and the firm's book-to-market ratio.

The discount rate in DCF valuation is the rate at which future cash flows are discounted to their present value, reflecting the opportunity cost of capital or the investor's required rate of return.

CAPM's main limitation is its assumption of constant risk-free rate and market return, which may not hold true in dynamic market conditions, leading to inaccurate asset pricing.

The Black-Scholes-Merton model assumes that stock prices follow a geometric Brownian motion, meaning their future movements are random and continuously changing, allowing for the calculation of option prices based on this assumption.