Asset Pricing Models Flashcards

1
Q
A

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

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2
Q

What are the similarities of APT to CAPM?

A
  • 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.
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3
Q

Is A or B over/undervalued?

A

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

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4
Q

What are CAPM Assumptions?

A
  • 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.
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5
Q
A

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%

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6
Q

What are the merits and drawbacks of CAPM?

A
  • 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
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7
Q

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

A
  • Correlation of stocks to portfolio
  • Volatility of stock
  • Liquidity
  • Ethical Issues
  • Exchange rate, sector and country
  • Portfolios tilts, growth, debt and value
  • Tax considerations
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8
Q

What is the right level of diversifaction?

A
  • 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.
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9
Q

What is global systemic risk

A
  • 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
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10
Q
A

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%.

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11
Q

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

A
  • 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.
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