Asset Pricing Models Flashcards
Expected return = risk free rate + (world beta x world expected risk premium) + (currency beta x currency exposure beta)
What are the similarities of APT to CAPM?
- 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.
Is A or B over/undervalued?
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
What are CAPM Assumptions?
- 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.
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%
What are the merits and drawbacks of CAPM?
- 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
What are considerations should the investor think about other than CAPM?
- Correlation of stocks to portfolio
- Volatility of stock
- Liquidity
- Ethical Issues
- Exchange rate, sector and country
- Portfolios tilts, growth, debt and value
- Tax considerations
What is the right level of diversifaction?
- 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.
What is global systemic risk
- 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
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%.
What are the merits and drawbacks of multi-factor models?
- 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.