Asset Pricing Models

Question 1

Capital asset pricing model (CAPM)

Question 2

Assumptions behind CAPM and normative approach to investing

Answer 2

Investors:
- Evaluate portfolios over a one period time horizon
- Are never satiated and will always choose the portfolio with a higher return between 2 with the same SD
- Are risk-averse and will always choose the portfolio with lower SD if 2 have the same expected returns
- Can buy a fraction of a share on an individual asset (infinitely divisible)
- May lend, invest or borrow money at a risk-free rate
- Taxes and transaction costs are irrelevant
- Have the same time horizon
- Have the same risk-free rate
- Have access to information instantly and freely
- Have homogeneous expectations/same perceptions in regard to the expected returns, SD and covariances of securities

Question 3

Capital Market Line (CML)

Answer 3

Linear efficient set in the world of CAPM, optimal asset allocation line, denominator is SD of market

Question 4

Slope of CML

Answer 4

Premium market return divided by SD of market

Question 5

Separation Theorem

Answer 5

Decision to buy the market portfolio is separate/independent from financing

Question 6

In the equilibrium world of the CAPM, a security that is not part of the market portfolio:

Answer 6

The market portfolio is the risky portfolio held by all investors. Therefore, a security that is not part of the market portfolio is not attractive to the risk-averse investor. An important feature of the CAPM is that in equilibrium each security must have a nonzero proportion in the composition of the tangency portfolio. That is, no security can, in equilibrium, have a proportion in the portfolio that is zero. Hence, the market portfolio is a set of securities that can be freely owned by investors.

Question 7

Arbitrage Pricing Theory (APT)

Answer 7

Alt model of pricing developed by Stephen Ross, less complicated than CAPM. Based on the law of one price (if a price is different in different markets, then a riskless profit exists for investors to buy security from the market with lower price and sell in the market with the higher price).

Question 8

Arbitrage portfolio conditions

Answer 8

Self-financing, riskless, positive return- There is negligible nonfactor risk in an arbitrage portfolio.

Question 9

Risk factors that significantly affected securities returns

Answer 9

Indicators of aggregate economic activity, inflation and interest rates/
Unanticipated changes in:
- inflation rate
- industrial production index
- yield spread between high and low grade corporate bonds
- yield curve slope

Question 10

How is the Behavioral Asset Pricing Model (BAPM) different from CAPM?

Answer 10

Each layer of pyramid of assets carries different attitudes toward risk, as opposed to the Markowitz Model (CAPM), which is based on consistent attitude toward risk

Question 11

Prospect Theory

Answer 11

Behavioral finance model based on:
Mental accounting- investors segment money in separate accounts, eg dividends and cap gains
Loss aversion>risk averse

Question 12

Difference between standard and behavioral finance

Answer 12

Validity of market efficiency - standard finance and its associated models such as CAPM, APT, Black-Scholes-Merton, and EMH assumes investors are rational and market is equilibrium-based. Behavioral assumes that investors are normal and make decisions based on feelings and are prone to cognitive errors and have biased expectations

Question 13

How is Beta determined under BAPM?

Answer 13

Using both utilitarian and value-expressive measures, with respect to the preferences of noise traders; but is difficult because the preferences of noise traders change over time.

Question 14

Binomial option pricing model

Answer 14

FV of an option based in underlying asset attaining one of two possible known prices at the end of each finite number periods, given its price at the start of each period

Question 15

Put-call parity

Answer 15

Relationship between the market prices of a call and a put on a given stock that have the same exercise price and expiration date. Allows investors to determine price of a call option given info about a put option of the same security, strike price and expiration date, and vice versa, illustrates two option premiums as inter-related
C-P=S-PV(X)

Question 16

Black-Scholes-Merton Option Valuation Model

Answer 16

FV of an option is determined by:
- current market price of underlying stock
- exercise price of option
- risk-free rate of return
- life of the option
- stock’s dividend yield
- risk of volatility
Assumes risk-free rate and common stock volatility are constant over the option’s life. Applicable to European options and options on stocks that will not pay any dividends over the life of the option

Question 17

Black-Scholes-Merton Measurements

Answer 17

Delta= impact of change in underlying stock price on stock option value. Positive for a call option and negative for a put option.
A $1 change to the stock price is approximately equivalent to change in option price by delta dollars.
Eta= percentage impact of change in stock price to the option value. Eta is positive for a call option and negative for a put option.
A 1% change to the stock price is approximately equivalent to change in option price by eta%.
Vega= impact of a change in the volatility of the stock on the stock option. Vega is positive for both a call option and a put option.
A 1% change to the stock’s standard deviation is approximately equivalent to change in option price by vega.
Gamma= delta’s sensitivity to a stock price change.
A $1 change in the stock price causes the delta to change by approximately the amount of gamma.
Theta = option price sensitivity to a change in time till expiration.
A one-day change to time to expiration will cause the option price to change approximately by theta.
Rho = option price sensitivity to a change in interest rate.
A 1% change to the interest rate will cause the option price to change approximately by rho.

Question 19

Which of the following is NOT a condition in defining an arbitrage portfolio?

Answer 19

There is significant nonfactor risk.