Chapter 7 - capital asset pricing and arbitrage pricing theory

Question 1

Capital asset pricing model(CAPM)

Answer 1

A model that relates the required rate of return on a security to its systematic risk as measured by beta

Question 2

assumptions of CAPM

Answer 2

• Investors are rational, mean-variance optimizers
• Markets are efficient

Question 3

implications of CAPM

Answer 3

• All investors will choose to hold the market portfolio (each security is held in proportion to its total market value)
• The market portfolio will be on the efficient frontier (optimal risky portfolio)
• The risk premium on the market portfolio will be proportional to the variance of the market portfolio and investors’ typical degree of risk aversion [E(rM) - rf = Āσ^2M]
• The risk premium on individual assets will equal the product of the risk premium on the market portfolio and the beta of the security

Question 4

Why all investors would hold the market portfolio? for CAPM

Answer 4

Assume all investors optimize their portfolios using the Markowitz model of efficient diversification

Question 5

Why is the passive strategy efficient for CAPM?

Answer 5

In the absence of private information, an investor whose risky portfolio differs from the market portfolio will end on a CAL inferior to the CML used by passive investors

Question 6

Mutual fund theorem

Answer 6

all investors desire the same portfolio of risky assets and can be satisfied by a single mutual fund composed of that portfolio

Question 7

CAPM’s expected return–beta relationship:

Answer 7

Implication of the CAPM that security risk premiums should be proportional to beta

Question 8

security market line

Answer 8

• Graphical representation of the expected return–beta relationship of the CAPM
• Graphs individual-asset risk premiums as a function of asset risk

Question 9

applications of CAPM

Answer 9

• Investment management: provides a benchmark to assess the expected return with an asset’s risk
• Capital budgeting: provides the required return demanded of the project, IRR, or hurdle rate
• Utility rate-making cases

Question 10

CAPM in the form of an index model

Answer 10

E(Rit) + rf = βS x (E(Rmt) - rft)

Question 11

what does Roll say about the true market portfolio?

Answer 11

it can never be observed

Question 12

multifactor models

Answer 12

Models of security markets positing that returns respond to several systematic factors

Question 13

Factors that affect investor welfare

Answer 13

1) factors that are correlated with prices of important consumption goods (housing and energy)

2) factors that are correlated with future investment opportunities (interest rate, return volatility, risk premiums)

3) factors that correlate with the state of the economy (industrial production and unemployment)

Question 14

The Fama-French three-factor model reasoning

Answer 14

• Average returns on stocks of small firms have been high than predicted by CAPM
• B/M has an impact on returns

Question 15

high B/M stocks

Answer 15

• value stocks
• derive a larger share of the MV from assets already in place
• May imply higher systematic risk than indicated by historical beta

Question 16

low B/M stocks

Answer 16

• growth stocks
• MV derives from anticipated growth in future CF

Question 17

value premium

Answer 17

value stocks have offered a higher average RoR than growth stocks

Question 18

Fama and French 3-factor model:

Answer 18

Rdisney,t - Rft = (ɑ)disney + βm(Rm,t - Rft) + (βhml x Rhml,t) + (βsmd x Rsmd,t) + (e)disney,t

Question 19

SMB (small minus big)

Answer 19

size factor in fama/french 3-factor model

Question 20

HML (high minus low)

Answer 20

• value vs growth factor
• the difference in returns in stocks with high vs low B/M

Question 21

arbitrage

Answer 21

Creation of riskless profits made possible by relative mispricing among securities

Question 22

Arbitrage pricing theory (APT)

Answer 22

A theory of risk-return relationships derived from no-arbitrage considerations in large capital markets

Question 23

beta of portfolio =

Answer 23

= average of betas of components

Question 24

Systematic variance =

Answer 24

= β^2 x σ^2m

Question 25

Portfolio nonsystematic variance =

Answer 25

= weighted sum of the individual firm-specific variance

Question 26

what does the APT say about frim specific risk?

Answer 26

it shouldn’t command a risk premium because it is easily eliminated

Question 27

what does the APT say about systematic risk?

Answer 27

risk premium should depend only on systematic risk that cannot be diversified

Question 28

dell diversified portfolio

Answer 28

A portfolio sufficiently diversified that nonsystematic risk is negligible

Question 29

APT vs CAPM

Answer 29

• APT highlights the distinction between non-diversifiable risk which requires a reward in the form of a risk premium
• CAPM relies on marginal trade-offs between risk and return in the mean-variance efficient portfolio

Question 30

factor portfolio

Answer 30

A well-diversified portfolio constructed to have a beta of 1 on one factor and a beta of 0 on any other factor