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.
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
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.
CAPM Formula
ri=rf+(rm−rf)βi
Ri = Return required
Rf = Risk free return
Rm = Market return
Bi = Beta for the investment
Capital Market Line
The capital market line (CML) represents the linear efficient set in the world of CAPM. All investors will hold a portfolio lying on the CML. It is the efficient frontier when borrowing and lending at the risk-free rate is permitted.
Security Market Line
The security market line is derived from the CAPM. According to the CAPM, in equilibrium, the risk premium on any asset is equal to its beta times the risk premium on the market portfolio. This relation is called the SML. It is an equilibrium relationship between the expected return and covariance with the market portfolio for all securities and portfolios. The slope of the SML is the risk premium on the market portfolio.
Market Risk Premium
Rm - Rf is the Market Risk Premium
Rm = Return rate of market
Rf = Risk free return (T Bonds)
Arbitrage Pricing Theory (APT)
ri =a+b1F1+b2F2+…+bkFk+ei
where:
ri = rate of return on security i
ai = the zero factor: the expected return when all factors = zero
Fk = the value of the factor, such as the rate of growth in industrial production
e = random error term
Bi = sensitivity of security i to the factor
Behavioral Asset Pricing Model (BAPM)
Behavioral Portfolio Theory, as defined by Sherfrin and Statman in 1999, presents the idea that investors build portfolios as “pyramids of assets.” Each layer in the pyramid (e.g., emergency funds, investment portfolio, qualified retirement funds, etc.) carries different attitudes toward risk. This is completely different from the Markowitz model (CAPM), which is based on consistent attitudes toward risk.
Capital Asset Pricing Model (CAPM)
The Model is better at predicting returns than analyzing historical trends.
