CAPM

Question 1

What are the CAPM Assumptions?

Answer 1

Perfect and Complete capital markets

Rational agents with homogenouos mean-variance preferences

No Transaction Costs/Tax

No credit constraints

Unlimited Shorting

Question 2

Roll’s Critique (1977)

Answer 2

1. Mean Variance Tautology
   Any mean-variance efficient portfolio necessarily satisfies the CAPM equation exactly–> given a proxy for the Market portfolio testing CAPM equivalent to testing for mean-variance efficiency–>assuming Mean-variance efficiency implies CAPM holds (tautology)
2. Market Portfolio unobservable–>involves all possible assets, can’t be observed so CAPM untestable

Question 3

Problems w/ interpreting findings

Answer 3

1.Cannot directly observe Beta
If B changes over time, evidence against CAPM may be result of mis-measuring Beta

2. Cannot observe expected returns directly
   Even if Beta is perfect measure of risk and CAPM is accurate actual returns may not reflect expected returns
3. Market proxy not comprehensive enough
   S&P 500 or FTSE 250 not a valid proxy for US stock market –> investors hold broader portfolio of assets including foreign stocks, real estate, commodities, jewellery, etc…

Question 4

Empirical Evidence re: CAPM

Answer 4

1. Data suggests SML is flatter in real life than model–> (rm-rf) is less than expected–> potentially due to mispecification of the market portfolio or underestimation of risk free asset. (Fama)
2. CAPM explains 70% of returns data

Question 5

Excess Returns

Answer 5

1. Size effect (Fama & French, 1983) - lower cap stocks have higher ave. returns
2. Value Effect (F&F, 83) - Stocks with higher BV/MV have higher ave returns –> BV = Shareholder Cap + Retained Earnings; MV = Share Price x Shares Outstanding
3. Momentum Effect - Stocks w/ past high returns tend to continue to have high ave. returns–> suggests momentum strategy is viable–> contradicts EMH

Question 6

Data Snooping Bias

Answer 6

Large enough sample with enough characteristics can generate spurrious relationships out of pure coincidence–> easy to identify characteristics that appear to be correlated with the error term

Question 7

Risk Factors or Mispriced stock

Answer 7

(Fama & French, 1983)
Value effect due latent risk -> firms w/ high book to value have assets undervalued by market–> increased financial risk–> req r goes up

David & Titman (1997) –> suggest OVB, third factor driving high alpha –> OVB not captured by prices–>Even controlling fo for financial distress increasd in BV/MV leads to increase in

Question 8

Implications of aplha =/= 0

Answer 8

1. Investors are systmatically ignoring profitable opportunities.
   If CAPM comutes risk premiums, but investors keep ignoring suggests:information assymetries (ignorance of opportunity);

transaction costs sufficiently high (net benefit of implementing strategy is neg)

Question 9

Fama & French and Fama, French & Cahart

Answer 9

3FM explains over 90% of diverfsified portfolicio
returns

FF extend model in 2015 to add two more regressors: profitability and investment

Empirical model–> purely descriptive/inductive–>relies on premise of time invariance–>future same as past

Question 10

Grossman-Stiglitz Paradox (1980)

Answer 10

Perfect information is impossible w/ information costs

If prices reflect all information then there are no gains from gathering information–>prices based on information so w/o info market unwinds

Info required to to compensate for cost of acquiring info and trading–> degree of information assymetry determines extent of effort market will be willing to put into info garthering and trading on info.

Question 11

David and Titman (1997)

Answer 11

suggest OVB, third factor driving high alpha –> OVB not captured by prices–>Even controlling for financial distress increases in BV/MV leads to increase Exp r

Question 12

Fama (1970) - Joint Hypothesis Problem

Answer 12

Market efficiency must be tested in the context of expected return. The joint hypothesis problem states that where a model produces a return significantly different from actual returns, one cannot be certain whether it is a result of ineffeciency in the market or ineffeciency in the model.

Question 13

Fama (1991)

Answer 13

Testing for market effeciency in itself in not possible. EMH can only be testing with a model of equilibrium, in such as an asset pricing model

Question 14

APT Assumptions

Answer 14

1. Arbitrage is impossible in a market equilibrium
2. Securities returns are functions of macro factors
3. Large number of traded assets

So arbitrage opportunity = asset mispriced

In reality stocks can face independent idiosynchratic shocks–> diversified away. So Arbitrage not completely riskless strictly speaking–> still specific risk.

Question 15

APT Limitations

Answer 15

Lacks theoretical framework

Difficult to identify omitted variables –> you never know when you’ve had enough

Incentive to ask regressors may have inflated R^2