Asset Pricing Models Flashcards
Capital asset pricing model (CAPM)
The capital asset pricing model (CAPM) provides an intuitive way of thinking about the return that an investor should require from an investment, given the asset’s systematic risk. It suggests that investors need not worry about the market portfolio. They only need to decide how much systematic risk they wish to accept. Market forces will ensure that any stock can be expected to yield the appropriate return.
Arbitrage pricing theory
The arbitrage pricing theory is an alternative theory that has gained acceptance in the financial community. Under this theory, a security’s price is explained by multiple economic factors rather than the single systematic risk factor.
Behavioral pricing model (BAPM)
The behavioral pricing model (BAPM) was developed to improve upon CAPM. At the heart of the model is the study of behavioral finance, which acknowledges the contributions of standard finance, but argues that people are “normal” instead of “rational.”
Binomial pricing model and the Black-Scholes-Merton pricing model
The binomial pricing model and the Black-Scholes-Merton pricing model provide formulas for determining the price of options, that is, their premiums. Binomial option pricing models are mathematically simple models that have been developed to deal with a broad class of valuation problems that include options, stocks, bonds and other risky financial claims. The Black-Scholes-Merton model was the first closed-form option-pricing model.
Capital Asset Pricing Model (CAPM)
The major implication of the CAPM is that the expected return of an asset is related to the measure of market risk for that asset known as beta.
This model provides the intellectual basis for a number of the current practices in the investment industry. Although many of these practices are based on various extensions and modifications of the CAPM, a sound understanding of the original version is necessary in order to understand them.
The capital market line
The capital market line - is the linear efficient set of the CAPM. The CML represents the equilibrium relationship between the expected return and standard deviation of efficient portfolios. The separation theorem states that an investor’s optimal risky portfolio can be determined without reference to the investor’s risk-return preferences. The market portfolio is the risky portfolio held by all investors consisting of all securities, each weighted in proportion to its market value relative to the market value of all securities.
The security market line
The security market line - is the linear relationship between market covariance and expected return. The slope of the SML indicates the level of aggregate investor risk aversion. Like the CML, the SML is an equilibrium risk-return relationship. In SML the relevant measure of risk for individual securities is the contribution that they make to the standard deviation of the market portfolio as measured by their respective covariances with the market portfolio or their betas. The beta is a measure of the covariance between the security and the market portfolio relative to the market portfolio’s variance.
The market model
The market model - is not an equilibrium model of security prices as is the CAPM. However, the beta from the CAPM is similar in concept to the beta from the market model. The market model differs from the CAPM in that it is a factor model while the CAPM is an equilibrium model. Further, the market model uses a market index while the CAPM uses the market portfolio. The market index is a subset of the CAPM’s market portfolio. The total risk of a security can be separated into market risk and non-market risk, under the CAPM. Each security’s non-market risk is unique to that security and hence is also termed its “unique risk.”
Arbitrage Pricing Theory (APT)
The capital asset pricing model is an equilibrium model that describes why different securities have different expected returns. In particular, this economic model of asset pricing asserts that securities have different expected returns because they have different betas. However, there exists an alternative model of asset pricing that was developed by Stephen Ross. It is known as arbitrage pricing theory, and in some ways it is less complicated than the CAPM.
One primary APT assumption is that each investor, when given the opportunity to increase the return of his or her portfolio without increasing its risk, will proceed to do so. The mechanism for doing so involves the use of arbitrage portfolios. An arbitrage portfolio is defined by three conditions:
- Self financing - Does not require additional funds from the investor.
- Riskless - There is no sensitivity to any factor; there is zero variance and covariance with other portfolios; and
there is negligible nonfactor risk. - Positive Return - the riskless arbitrage will result in a positive return.
Factor Model - Factors
Stephen Ross and Richard Roll employed factor analytic techniques to analyze 1,260 NYSE-listed stocks divided into 42 groups that contained 30 stocks each. They analyzed one decade of daily stock price returns. They concluded there were four or fewer significant risk factors. These factors represented unanticipated changes in four variables (note this wording—unanticipated changes is a key point):
Changes in the rate of inflation
Changes in the index of industrial production
Changes in the yield spread between high-grade and low-grade corporate bonds, a measure of investor confidence
Changes in the slope of the term structure of interest rates, as measured by the difference between the yields on long-term government bonds and T-bills
Different researchers reported other risk factors. The most commonly identified factors that affect expected returns are indicators of aggregate economic activity, such as corporate earnings and dividends, inflation and interest rates.
