7. Asset Pricing Models Flashcards
What change would you expect in the standard deviation for a portfolio of between 4 and 10 stocks, 10 and 20 stocks, 50 and 100 stocks?
- SD would be expected to decrease with an increase in stocks in the portfolio because an increase in number will increase the probability of having more low and inversely correlated stocks.
- Major decline from 4-10 stocks, continued from 10-20 but at a slower rate (almost all unsystematic risk is eliminated by 18 stocks)
Explain how the following economic factor will affect portfolio risk and return: INDUSTRIAL PRODUCTION (MP)
- Related to CFs in the traditional discounted cash flow formula.
- The relative performance of a portfolio sensitive to unanticipated changes in industrial production should move in the SAME DIRECTION as the change in this factor.
- These portfolios should be compensated for unanticipated changes in this factor
Explain how the following economic factor will affect portfolio risk and return: INFLATION (DEI)
- Reflected in the discount rate (k)
- Unexpected inflation will quickly be factored into k by the market as investors attempt to hedge the loss of purchasing power. Thus, the k would move in the same direction
- High inflation could also affect CFs in the DCF formula, but the effect will probabily be more than offset by higher discount rate
- Higher unanticipated inflation will have a negative effect on portfolio values
Explain how the following economic factor will affect portfolio risk and return: RISK PREMIA (UPR)
- Affects the magnitude of the DCF discount rate (k).
- Represents investor attitudes toward risk-bearing and perceptions of uncertainty
- When the return in low vs. high quality bonds widens, there is likely to be a NEGATIVE impact on the values of stocks and bonds
Explain how the following economic factor will affect portfolio risk and return: TERM STRUCTURE
- Unexpected changes in term structure affect the DISCOUNT RATE
- With HIGH DISCOUNT RATES, PORTFOLIO VALUES FALL.
- If the curve becomes steeper, longer duration assets would be NEGATIVELY affected more than short-term assets
Explain how the following economic factor will affect portfolio risk and return: AGGREGATE CONSUMPTION
- Will affect CFs in the DCF formula.
- Increased (decreased) levels of spending by consumers will likely lead to increases (decreases) in economic activity and corporate earnings
Explain how the following economic factor will affect portfolio risk and return: OIL PRICES
- Likely will affect CFs in the DCF formula.
- Higher oil prices will lead to higher inflation as oil is a cost component for many items (transport)
- Larger effect is that consumers may see higher oil prices and reduce their spending
Non-standard CAPMs: Differential borrowing and lending rates
- In reality investors can only borrow at a higher rate (than gov bond rate) and lend money at a lower rate than the borrowing rate
- When borrowing rate (Rb), is higher than RFR, the SML will be “broken” into two lines
Non-standard CAPMs: Zero Beta model
- Zero-beta portfolio does not have systematic risk but it may have some unsystematic risk
- Instead of a risk-free rate, a zero-beta portfolio (uncorrelated with the market) can be used to draw the SML with a less steep slope
Non-standard CAPMs: Many investors, transaction costs
- Absence of transaction costs in standard CAPM means investors will buy/sell mispriced securities
- With transaction costs, investors will not correct all mispricings (costs higher than returns)
- Capital markets do not have perfect competition and they are imperfectly competitive
- With t-costs, the SML will be a band of securities, rather than a straight line
Non-standard CAPMs: Heterogeneous expectations and planning periods
-Create a band of lines
Non-standard CAPMs: Taxes
Causes major difference between the CML and SML
Assumptions of Capital Market Theory (CAPM)
- Efficient investors who target points on the efficient frontier, risk-return utility function
- No single investor can affect the price of a stock
- Investors can borrow or lend any amount at the RFR
- All investors have homogeneous expectations
- All investors have the same time horizon
- All investments are infinitely divisible
- No taxes/transaction costs
- Non inflation or change in interest rates
- Capital markets are in equilibrium
Arbitrage Pricing Model (APT) assumptions and contrast with CAPM
-Based on the law of one price
1. Capital markets are perfectly competitive
2. Investors always prefer more wealth to less wealth
3. Stochastic process generating returns can be expressed as a linear function of a set of K factors
In contrast to CAPM, APT does not assume:
1. Normally distributed returns
2. Quadratic utility function
3. A mean-variance efficient market portfolio
