Arbitrage pricing theory

Question 1

What are the two sources of security returns?

Answer 1

The two main sources of security returns are a common macroeconomic factor and firm specific events

Question 2

What are two main macro factors affecting returns?

Answer 2

The two main macro factors affecting security returns are interest rates and GDP

Question 3

In Ri = E(Ri) + BF + ei, what are the coefficients?

Answer 3

In the above equation, E(Ri) is the expected return of the investment, B is the sensitivity of the security to a factor, and F is the value of a shock in that factor. Ei is a firm-specific event

Question 4

Both F and e have … … value

Answer 4

Both F and E have zero expected value

Question 5

The APT predicts a security market line linking … … to …

Answer 5

The APT predicts a security market line linking expected returns to risk

Question 6

What are the three propositions of the APT SML?

Answer 6

• Securities described with a factor model
• There are enough securities to diversify away idiosyncratic (firm-specific) risk
• Arbitrage will disappear quickly

Question 7

What is an arbitrage opportunity?

Answer 7

An arbitrage opportunity is when a zero-investment portfolio has a sure profit

Question 8

Why do investors take large positions in arbitrage opportunities?

Answer 8

Investors take large positions in these arbitrage opportunities because they are risk free and investors want to therefore maximise their returns before the opportunity closes.

Question 9

Investors want a large position in the risk free arbitrage portfolio regardless of … … or …

Answer 9

Investors want a large position in the risk free arbitrage portfolio regardless of risk aversion or wealth

Question 10

What will happen to profitable arbitrage opportunities in efficient markets?`

Answer 10

Profitable arbitrage opportunities in efficient markets will close when the lower priced asset is bid up in price, and the higher priced asset is shorted down. (They will disappear quickly)

Question 11

What is the critical assumption of CAPM?

Answer 11

The critical assumption of the CAPM model is that a large number of investors are mean-variance optimisers

Question 12

Explain what the terms mean for a single factor portfolio above

Answer 12

Above, for a single factor portfolio, Bp is the weighted factor sensitivity, E(rp) is the weighted expected return, wi = 1 means the weights add to 100% (1)

Question 13

In a well-diversified portfolio, ep Approaches … as the number of … in the … increases and their associate weights … `

Answer 13

In a well-diversified portfolio, ep approaches zero as the number of stocks in the portfolio increases and their associate weights decrease.

Question 14

We can conclude any realized value of ep will be virtually …

Answer 14

We can conclude any realized value of ep will be virtually zero

Question 15

When two assets have different returns but the same … there is an … opportunity

Answer 15

When two assets have different returns but the same beta there is an arbitrage opportunity

Question 16

Why will arbitrage opportunity mean alpha/risk premium is equal to zero?

Answer 16

Arbitrage opportunity means alpha/risk premium is equal to zero because we can expect arbitrage opportunities to be cancelled out by an efficient market, meaning alpha, which represents the non-market return, is equal to zero.

Question 17

APT equilibrium means no … opportunities

Answer 17

APT equilibrium means no arbitrage opportunities

Question 18

What happens to APT equilibrium upon arbitrage?

Answer 18

Upon arbitrage, the APT equilibrium is restored.

Question 19

APT assumes a … portfolio

Answer 19

APT assumes a diversified portfolio, where residual risk is still a factor

Question 20

CAPM model is based on a … portfolio

Answer 20

The CAPM model is based on an unobservable market portfolio

Question 21

CAPM rests on …-… efficiency

Answer 21

CAPM rests on mean-variance efficiency, where the actions of many investors restore CAPM.

Question 22

CAPM describes … for all …

Answer 22

CAPM describes equilibrium for all assets

Question 23

To select factors for the multifactor APT, we choose those that are important to…

Answer 23

To select factors for the multifactor APT, we choose factors that are important to the performance of the general economy.

Question 24

Factor portfolios track… but are uncorrelated with…

Answer 24

Factor portfolios track a particular economic risk source, but are uncorrelated with other sources of risk.

Question 25

Under multi factor CAPM, each factor portfolio has B=… for one factor and B=… for all other factors

Answer 25

Under multi factor CAPM, each factor portfolio has B = 1 for one factor and B=0 for all other factors

Question 26

Each MFAPT portfolio can be interpreted as either a … … itself, or a portfolio of … correlated with the … … …

Answer 26

Each multifactor APT portfolio can be interpreted as either a risk factor itself, or a portfolio of stocks correlated with an unobservable risk factor.

Question 27

In the Fama and French model, what are the 3 systematic factors?

Answer 27

• Firm size
• Book to market ratio
• The market index

Question 28

What alphas do value stocks and growth stocks tend to have?

Answer 28

Growth stocks tend to have low or negative alphas, whereas value stocks tend to have positive alphas

Question 29

What is the only way positive alpha strategies can persist in a market?

Answer 29

The only way positive alpha strategies can exist in a market are if some barrier to entry restricts competition `

Question 30

If the market portfolio is not efficient, then what does this mean about a stock’s beta?

Answer 30

If the market portfolio is not efficient, then this means a stock’s beta with the market is therefore not an adequate measure of systematic risk

Question 31

The model shows that portfolios with higher average … tend to have higher …

Answer 31

The model shows that portfolios with higher average returns tend to have higher betas

Question 32

Small minus big portfolio places firms into two portfolios based on…

Answer 32

Small minus big portfolio places firms into two portfolios based on market capitalization of equity

Question 33

What is the condition for big or small?

Answer 33

The criterion for big or small is whether the value is above or below the median market value

Question 34

What is the Book to market ratio strategy?

Answer 34

The book to market ratio strategy is when stocks are selected based on the value of their book relative to their market capitalisation, and split into low and high portfolios