CAPM

Question 1

6 CAPM Assumptions

Answer 1

HIATUS

1) All investors are small compared to overall market (perfect competition → price takers)
2) The model is one-period
3) All assets/securities are equally available/tradable (even human capital)
4) No taxes or transaction costs
5) Unlimited borrowing and lending at the risk-free rate
6) Everyone has the same mean variance optimization problem and approaches it with same beliefs: homogenous assumptions and expectations

Question 2

What are mean-variance preferences?

Answer 2

Expected utility depends only on mean and variance of possible outcomes. Avoids issues of loss aversion.

Question 3

Black et al.

Answer 3

1972

SML line flatter in real life than in theory

Fama and French 2004, confirm this with a study of 912 monthly returns for ten beta-sorted portfolios.

Question 4

Blume

Answer 4

1973

Adjusted Beta of Security =2/3*Bi + 1/3 (1)

Question 5

Banz

Answer 5

1981

Size effect, lower market cap firms have higher average returns.

Question 6

Stattman

Answer 6

1980

Stocks with higher book-market ratios have been found to have higher returns

Question 7

APT Assumptions

Answer 7

1. Securities’ returns are functions of (macro) factors

2. There is a large number of traded assets (greater than number of factors)

Question 8

Ross

Answer 8

1976

APT

Question 9

Merton

Answer 9

1973

ICAPM

Question 10

Order of Essay

Answer 10

CAPM (Assumptions, Model)
Leads to SML
Black et al. (1972)
Other factors affect returns: Stattman (1980), Banz (1981), Jegadeesh and Titman (1993), Wachtel (1942), P/E ratio, dividend yield

Testing the CAPM
Testable Typotheses

Criticize the assumptions.
Other issues: Endogeneity, Roll (1977), Identifying market portfolio
Behavioural finance
But CAPM is predominant model

Alternatives to CAPM
Consumption Based
Ross (1976)
Multifactor models 
ICAPM
Black CAPM

Question 11

CAPM Testable hypotheses

Answer 11

1. Test that E(r) increases linearly with beta (i.e. everything is on the SML)
2. Test that only risk measured by beta affects returns
3. Market portfolio is mean variance efficient

Question 12

Endogeneity between Beta and R

Answer 12

Since 𝛽𝑖 =𝑐𝑜𝑣 (𝑟𝑖,𝑟𝑚)

Question 13

APT Formula

Answer 13

e(ri) = rf + sum to j of Betaij Lambaj

Question 14

Roll

Answer 14

1977

Mean-Variance Tautology: Given a proxy for the market portfolio, testing the CAPM equation is equivalent to testing mean-variance efficiency of the portfolio. The CAPM is tautological if the market is assumed to be mean-variance efficient.

The Market Portfolio is Unobservable

Question 15

Jagganathan and McGrattan

Answer 15

1995

Only 1/3 assets are equity financed, market portfolio cannot be S&P.