CAPM CCAMP APT Flashcards
The model for the arbitrage pricing theory contains the factor F: what does this factor represent?
The factor F represents the deviation of the common factor from its expected value. Also known as the deviation from its expected value of a factor that affects all security returns.
Does the CAPM and/or the APT provide guidance concerning determining the risk premium
on factor portfolios?
a. Both the CAPM and the multifactor APT
b. Neither the CAPM nor the multifactor APT
c. Only the CAPM
d. Only the multifactor APT
Only the CAPM
!The Capital Asset Pricing Model is one of the most well-known asset pricing models. Please:
- Explain the logic behind relating required returns to beta instead of the standard deviation;
- Report the conclusions regarding the regression slope drawn by scholars who tested the CAPM;
- Relate the existence of low-volatility investing to this answer
- Beta vs. Standard Deviation in CAPM:
- CAPM uses beta because it assumes all investors hold the market portfolio, diversifying away the firm-specific risk. Beta measures an asset’s sensitivity to market movements, making it the relevant risk measure.
- CAPM Regression Slope Conclusions:
- Studies find the CAPM regression slope is too small. This means the expected market risk premium is smaller than observed, indicating that beta alone may not fully capture risk.
- Low-Volatility Investing and CAPM:
- Low-volatility investing challenges the idea that higher beta leads to higher returns. Low-beta stocks often provide higher returns than CAPM predicts. This supports the notion that beta may not capture all relevant risk factors.
Explain the logic behind relating required returns to beta instead of the standard deviation;
Under the CAPM, the market portfolio is the optimal portfolio. Investors only incur market risk, which is measured by beta. Firm-specific risks, represented by the standard deviation, are diversified away.
Which characteristic of the arbitrage pricing theory (APT) potentially provides the largest benefits over the CAPM?
a. Superior measurement of the risk-free rate of return over historical time periods.
b. The variability of coefficients of sensitivity to the APT factors for a given asset over time.
c. The identification of anticipated changes in production, inflation, and term structure as key factors in explaining the risk-return relationship.
d. The use of several factors instead of a single market index to explain the risk-return relationship.
The use of several factors instead of a single market index to explain the risk-return relationship.
The efficient frontier is..
…the set of optimal portfolios that offers the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.
Portfolios that lie below the efficient frontier are sub-optimal, because they do not provide enough return for the level of risk.
Elaborate on CAPM extensions and how they can help explain the conclusions from the first and second pass regression:
The CAPM extensions address different assumptions of the CAPM that maybe unrealistic.
For example, the Black CAPM (Zero-Beta Model) addresses the assumption that investors can borrow and lend at a common risk-free rate.
The Intertemporal CAPM (ICAPM) addresses the assumption that investors have a single period planning horizon and account for extra market sources of risk
The benchmark of the arbitrage pricing theory is required to…
… any well-diversified portfolio lying on the SML can serve as the benchmark portfolio for the APT.
The true (and unobservable) market portfolio is only a requirement for the CAPM.
True
How would you incorporate liquidity into the CCAPM (Consumption Capital Asset Pricing Model)
In the same way, it would be incorporated into the conventional CAPM.
In CAPM, the expected return E(r), in addition to the market risk premium, also depends on the expected cost of illiquidity and three liquidity-related betas which measure the sensitivity of:
- the security’s illiquidity to market illiquidity
- the security’s return to market illiquidity
- the security’s illiquidity to the market return.
A similar approach can be used for the CCAPM, except that the liquidity betas would be measured relative to consumption growth.
The risk premium is…
…the difference between the return on a risky investment and the return on a
risk-free investment (government bonds).
If the forecast rate of return is less than the required rate of return (CAPM), then the security is….
overvalued
Two investors are comparing performance. One averaged a 20% rate of return and the other 18% rate of return. However, the beta of the first is 1.6 and the second 1.
Can you tell which investor was a better sector of individual stock (aside from the issue of general movements in the market?)
Νο.
We need the rf and rm in order to calculate the abnormal returns of each.
According to CAMP the expected return of a portfolio with a beta of 1.0 and alpha of 0 is:
- between the rm and rf
- the risk-free rf
- b(rm - rf)
- the expected return on the market rm
the expected return on the market rm
Two portfolios have the following characteristics:
A: beta 1.0, the specific risk for each security
A: beta 1.0, low specific risk for each security
Briefly explain whether investors should expect a high return from holding portfolio A versus portfolio B under asset pricing theory (CAPM). Assume that both portfolios are well diversified.
Under the CAPM, the only risk that investors are compensated for bearing is the risk that cannot be diversified away (systematic risk, beta).
Because systematic risk (measured by beta) is equal to 1.0 for both portfolios, an investor would expect the same rate of return from both portfolios A and B.
Moreover, since both portfolios are well diversified, it doesn’t matter if the specific risk of the individual securities is high or low. The firm-specific risk has been diversified away for both portfolios.
Under the CAPM, the only risk that investors are compensated for the bearing is the.
… the risk that cannot be diversified away (systematic risk).
If a portfolio is well diversified which risk is irrelevant (diversified away):
- (firm) specific risk
- systemic risk (beta)
- (firm) specific risk SD or σ
When a stock is held as a single stock portfolio, the standard deviation is … risk measure and beta …
SD relevant
beta irrelevant
The APT itself does not guide the factors that one might expect to determine risk premiums. How should researchers decide which factors to investigate? Why for example is industrial production a reasonable factor to test for a risk premium?
APT factors must correlate with major sources of uncertainty. One should investigate factors which correlate with uncertainty in consumption and investment opportunities, such as GDP, the inflation rate, and interest rates.
Industrial production may be a good indicator of changes in the business cycle thus may correlate highly with uncertainties regarding investment and consumption opportunities.
Claim: The APT factors must correlate with major sources of uncertainty, i.e., sources of uncertainty that are of concern to many investors.
True,
Researchers should investigate factors that correlate with uncertainty in consumption and investment opportunities.
GDP, the inflation rate, and interest rates are among the factors that can be expected to determine risk premiums.
A portfolio with a beta of 0 is…
… the risk-free
A portfolio with a beta of 1.0 and alpha of 0 is the…
… market portfolio
Suppose that two actors have been identified for the US economy: the growth rate of industrial production IP and the inflation rate IR. IP is expected to be 5% and IR 4.2%. A stock with a beta of 1.6 on IP and 1.1 IR currently is expected to provide a rate of return of 13%. If industrial production grows by 7% while the inflation rate turns out to be 5.5% what is your revised estimate of the expected rate of return on the stock?
E(r) ‘ = E(r) +- (biΔIP + b2ΔIR)
The revised estimate of the expected rate of return on the stock would be the old estimate plus (since it is an increase with positive b) the sum of the products of the unexpected change in each factor times the respective sensitivity coefficient:
Revised estimate = 13% + [(1.6 × 2%) + (1.1 × 1.3%)] = 17.63%
Note that the IP estimate is computed as: 1.6 × (7% - 5%), and the IR estimate is computed as:
1.1 × (5.5% - 4.2 %).
Report the conclusions regarding the regression slope drawn by scholars who tested theCAPM. Relate the existence of low-volatility investing to this answer.
It turns out the the (rm-rf) is lower than in reality, in other words, the slope of the regression line is too small.
Therefore low-beta shares get higher returns than expected, and high-betashares lower returns than justified by their beta.