Asset Pricing Models

Answer 1

Expected return = risk free rate + (world beta x world expected risk premium) + (currency beta x currency exposure beta)

Question 2

What are the similarities of APT to CAPM?

Answer 2

• Both are equilibrium theories of expected return
• Both use the risk-free rate as their intercept
• Beta in the CAPM is a composite factor which is equivalent to the weighted average of the beta of the relevant factors in the APT model.
• In equilibrium there is no unsystematic return, all expected returns derive from systemic risk.

Question 3

Is A or B over/undervalued?

Answer 3

If required return is larger than expected return then it will sit under the CML and is overvalued

If CAPM > Expected return it is overvalued

If CAPM < Expected return it is undervalued

Question 4

What are CAPM Assumptions?

Answer 4

• Mean and variance are enough to described investors preferences over the distributions of future returns in a portfolio.
• Investors prefer higher expected returns to lower expected returns for a given portfolio risk and prefer lower volatility to higher volatility for a given portfolio expected return.
• All investors can borrow and lend at the risk-free rate.
• All investors have the same expectations about means, variances and co-variances of security returns.

Answer 5

As the stocks were not sold there is no tax implications for stock A

Required return for stock A = 0.5% + 0.9%(5% - 0.5%) = 4.5%. The expected return for stock A is 5.2%. Stock A is undervalued and sits above the SML.

Stock B pays dividend so need to find after-tax returns.

10% dividend tax paid at source, so gross-up dividend = 4% x 1.1 = 4.4% and then reduce by the dividend tax of 32.5% = 4.4% x 0.675 = 3%. The required return for stock B is therefore 2% capital gain + 3% dividend return = 5%

Question 6

What are the merits and drawbacks of CAPM?

Answer 6

• Merits:
  
  • Easy to calculate
  • Simple to understand
  • CAPM beta is the most important single factor so justified the focus
  • CAPM only set out to explain one return factor
  • Relevant for diversified investors
• Drawbacks:
  
  • Security beta are unstable
  • Risk free specification problems
  • The true portfolio is univestable
  • Transaction costs are not included

Question 7

What are considerations should the investor think about other than CAPM?

Answer 7

• Correlation of stocks to portfolio
• Volatility of stock
• Liquidity
• Ethical Issues
• Exchange rate, sector and country
• Portfolios tilts, growth, debt and value
• Tax considerations

Question 8

What is the right level of diversifaction?

Answer 8

• Risk falls to systemic risk and is often reached at around 15-30 stocks
• Holding more securites raises transaction costs for no extra risk reduction
• Recent empirical research find that the co-movement of financial markets have increased over time making diversification harder to achieve
• Unsystematic risk is harder to remove when low postive zero or negative correlations are in practice difficult to find
• Doesn’t explain why institutional portfolios most often hold 70 lines of stock, a persistent anomaly to the story.

Question 9

What is global systemic risk

Answer 9

• Outlook which is orentated to the home market and include infaltion, interest rates, exchange rates and government stance.
• Some of these factors exhibit idisyncratic variation which is to a degree diversificable.
• Factors such as the price of oil, water and other essential commodites for which there are no substitues
• Event-specifc common factors also make good examples such as COIVD-19

Answer 10

Expected return = risk free rate + (factor 1 x beta 1) + (factor 2 x beta 2) + (factor 3 x beta 3)

In a multi-factor model the risk factors can be over a macroeconomic variety or they can be viewed at a micro or firm level

Expected return = 2% + (1.5%) x (1.0) + (2.5%) x (2.0) + (6.0%) x (0.0) = 8.5%.

Question 11

What are the merits and drawbacks of multi-factor models?

Answer 11

• Merits:
  
  • Add more factors to original CAPM so remains fairly streightforward to understand and calculate
  • Improved our understanding and explanation of total return
  • Adds persistent anomalies from EMH evidence so has a second eveidence base
  • Factors can be useful when taking a factor or TAA approach
• Drawbacks:
  
  • Not sure what specifc metric is best proxy for the factor
  • Fiddly and hard to calcaulte although modern computer
  • Unsure whether the factors are rewards for other risks
  • Debate about this risk premium or whether smaller firms are just more risky.