CAPM Flashcards
A multi-factor model is sometimes used as an alternative to the Capital Asset Pricing Model.
Determine which of the following statements must be TRUE regarding the multi-factor model.
A
Investors incur taxes and/or transaction costs in trading securities.
B
Investors have varying expectations regarding the volatilities, correlations, and expected returns of securities.
C
The market portfolio of securities is efficient.
D
It is necessary to identify the efficient portfolio to calculate the expected return of a security.
E
A collection of well-diversified portfolios can be used to calculate the expected return of a security.
Statement A is false. The Berk/DeMarzo text does not mention anything about taxes and/or transaction costs when discussing the multi-factor model.
Statement B is false. The Berk/DeMarzo text does not mention anything about investor’s expectations regarding the volatilities, correlations, and expected returns of securities when discussing the multi-factor model.
Statement C is false. According to the Berk/DeMarzo text, the reason why the multi-factor model is used as an alternative to the CAPM is because the market portfolio may not be efficient.
Statement D is false and Statement E is true. It is extremely difficult to identify efficient portfolios because we cannot measure the expected return and the standard deviation of a portfolio with great accuracy. Fortunately, we can construct an efficient portfolio from other well-diversified portfolios. It is not necessary to identify the efficient portfolio itself; as long as we can identify a collection of well-diversified portfolios from which an efficient portfolio can be constructed, we can use the collection itself to calculate the expected return of a security.
Determine which of the following statements is TRUE.
A
Beta measures market risk whereas volatility measures firm-specific risk.
B
In a well-diversified portfolio, market risk accounts for a considerably greater proportion of total risk than firm-specific risk.
C
A portfolio’s beta is the arithmetic average of all the betas for the individual stocks in the portfolio.
D
A stock’s beta is the ratio of the covariance between the stock returns and the market returns to the standard deviation of market returns.
E
The average beta of a stock in the market is greater than 1.
Statement A is false.
Beta measures market risk whereas volatility measures total risk, which includes both market and firm-specific risks.
Statement B is true.
Diversification reduces a portfolio’s total risk by averaging out non-systematic fluctuations. Non-systematic risks (also known as firm-specific, independent, idiosyncratic, unique, or diversifiable risks) can be reduced through diversification, whereas systematic risks (also known as common, market, or undiversifiable risks) cannot be avoided through diversification.
Thus, when we combine many firms’ stocks into a portfolio, only non-systematic risks (firm-specific risks) will be removed. The portfolio volatility will decline until only the systematic risk (market risk) remains. As a result, in a well-diversified portfolio, market risk accounts for a considerably greater proportion of total risk than firm-specific risk.
Statement C is false.
A portfolio’s beta is the weighted average of all the betas for the individual stocks in the portfolio.
Statement D is false.
A stock’s beta is the ratio of the covariance between the stock returns and the market returns to the variance of market returns.
Statement E is false.
The average beta of a stock in the market is about 1.
Determine which of the following statements about the Capital Asset Pricing Model is TRUE.
A
Assuming the market risk premium is positive, if an investment has a negative beta, then its expected return would be less than the risk-free rate.
B
The expected return on an investment with a beta of 2 is two times as high as the expected return on the market portfolio.
C
A security with a beta of 0 will offer zero expected return.
D
If a stock lies below the security market line, it is undervalued.
E None of (A), (B), (C), and (D) are correct.
The CAPM states that:
E[Ri]=rf+βi(E[RMkt]−rf)
Statement A is true.
If βi<0, then E[Ri]
According to the CAPM, the stock with the highest beta will demand the highest risk premium.
You are given the following information regarding four stocks:
Stock Volatility ρi,Mkt A 0.25 0.5 B 0.10 0.8 C 0.33 0.3 D 0.40 0.2
Determine which one of the following statements regarding multi-factor models is NOT true.
A
A collection of well-diversified portfolios, from which an efficient portfolio can be constructed, can be used to measure risk.
B
These models are also referred to as the Arbitrage Pricing Theory.
C
Taxes and transaction costs are incorporated when estimating the expected rate of return for a multi-factor model.
D
The market portfolio of securities is not necessarily efficient.
E
Small-Minus-Big (SMB) and High-Minus-Low (HML) portfolios are part of the Fama-French-Carhart multi-factor model.
Statement C is false:
Neither taxes nor transaction costs need be considered in a multi-factor model.
Statement A is true:
In practice, since it is difficult to measure the expected return and the standard deviation of a portfolio with great accuracy, it is difficult to identify efficient portfolios. However, because we can construct an efficient portfolio from other well-diversified portfolios, it is not actually necessary to identify the efficient portfolio itself. As long as we can identify a collection of well-diversified portfolios from which an efficient portfolio can be constructed, we can use the collection itself to measure risk.
Statement B is true:
A multi-factor model is also known as the Arbitrage Pricing Theory (APT).
Statement C is false:
Neither taxes nor transaction costs need be considered in a multi-factor model.
Statement D is true:
The market portfolio of securities is not necessarily efficient. When market portfolio is not efficient, we need to find an alternative method to estimate the expected return of a security, such as using a multi-factor model.
Statement E is true:
The Fama-French-Carhart (FFC) factor specification considers 4 factors: market, market capitalization, book-to-market ratios, and momentum. The FFC estimates the expected return as:
E[Ri]=rf+βMkti⋅(E[RMkt]−rf)+βSMBi⋅E[RSMB]+βHMLi⋅E[RHML]+βPR1YRi⋅E[RPR1YR]
where:
MktSMBHMLPR1YR=Market portfolio=Small-minus-big portfolio=High-minus-low portfolio=Prior 1-year momentum portfolio
