Arbitrage pricing theory Flashcards
What are the two sources of security returns?
The two main sources of security returns are a common macroeconomic factor and firm specific events
What are two main macro factors affecting returns?
The two main macro factors affecting security returns are interest rates and GDP
In Ri = E(Ri) + BF + ei, what are the coefficients?
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
Both F and e have … … value
Both F and E have zero expected value
The APT predicts a security market line linking … … to …
The APT predicts a security market line linking expected returns to risk
What are the three propositions of the APT SML?
- Securities described with a factor model
- There are enough securities to diversify away idiosyncratic (firm-specific) risk
- Arbitrage will disappear quickly
What is an arbitrage opportunity?
An arbitrage opportunity is when a zero-investment portfolio has a sure profit
Why do investors take large positions in arbitrage opportunities?
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.
Investors want a large position in the risk free arbitrage portfolio regardless of … … or …
Investors want a large position in the risk free arbitrage portfolio regardless of risk aversion or wealth
What will happen to profitable arbitrage opportunities in efficient markets?`
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)
What is the critical assumption of CAPM?
The critical assumption of the CAPM model is that a large number of investors are mean-variance optimisers
Explain what the terms mean for a single factor portfolio above
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)
In a well-diversified portfolio, ep Approaches … as the number of … in the … increases and their associate weights … `
In a well-diversified portfolio, ep approaches zero as the number of stocks in the portfolio increases and their associate weights decrease.
We can conclude any realized value of ep will be virtually …
We can conclude any realized value of ep will be virtually zero
When two assets have different returns but the same … there is an … opportunity
When two assets have different returns but the same beta there is an arbitrage opportunity
Why will arbitrage opportunity mean alpha/risk premium is equal to zero?
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.
APT equilibrium means no … opportunities
APT equilibrium means no arbitrage opportunities
What happens to APT equilibrium upon arbitrage?
Upon arbitrage, the APT equilibrium is restored.
APT assumes a … portfolio
APT assumes a diversified portfolio, where residual risk is still a factor
CAPM model is based on a … portfolio
The CAPM model is based on an unobservable market portfolio
CAPM rests on …-… efficiency
CAPM rests on mean-variance efficiency, where the actions of many investors restore CAPM.
CAPM describes … for all …
CAPM describes equilibrium for all assets
To select factors for the multifactor APT, we choose those that are important to…
To select factors for the multifactor APT, we choose factors that are important to the performance of the general economy.
Factor portfolios track… but are uncorrelated with…
Factor portfolios track a particular economic risk source, but are uncorrelated with other sources of risk.
Under multi factor CAPM, each factor portfolio has B=… for one factor and B=… for all other factors
Under multi factor CAPM, each factor portfolio has B = 1 for one factor and B=0 for all other factors
Each MFAPT portfolio can be interpreted as either a … … itself, or a portfolio of … correlated with the … … …
Each multifactor APT portfolio can be interpreted as either a risk factor itself, or a portfolio of stocks correlated with an unobservable risk factor.
In the Fama and French model, what are the 3 systematic factors?
- Firm size
- Book to market ratio
- The market index
What alphas do value stocks and growth stocks tend to have?
Growth stocks tend to have low or negative alphas, whereas value stocks tend to have positive alphas
What is the only way positive alpha strategies can persist in a market?
The only way positive alpha strategies can exist in a market are if some barrier to entry restricts competition `
If the market portfolio is not efficient, then what does this mean about a stock’s beta?
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
The model shows that portfolios with higher average … tend to have higher …
The model shows that portfolios with higher average returns tend to have higher betas
Small minus big portfolio places firms into two portfolios based on…
Small minus big portfolio places firms into two portfolios based on market capitalization of equity
What is the condition for big or small?
The criterion for big or small is whether the value is above or below the median market value
What is the Book to market ratio strategy?
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
