FRM6 - The Arbitrage Pricing Theory and Multifactor Models of Risk and Return Flashcards
Explain Arbitrage Pricing Theory (APT), describe its assumptions, and compare the APT to CAPM
APT suggests multiple factors can help explain the expected rate of return on a risky asset
Assumptions:
1. Asset returns can be explained by systematic factors that affect all securities
2. By using diversification, investors can eliminate specific risk from their portfolios
3. There are no arbitrage opportunities among well diversified portfolios
APT does not assume investors hold efficient portfolios as in CAPM. CAPM is special one-factor case of APT.
Describe the inputs (including factor betas) to a multifactor model and explain the challenges of using multifactor models in hedging
Bik is coefficient measuring effect of changes in factor Ik on rate of return on security i
Ik - E(Ik) is difference between observed and expected values of factor k
Model risk, more assumptions means more likely to go wrong. Incorrect assumptions (linearity for example) will lead to incorrect hedging. Assuming stationarity also an issue.
Calculate the expected return of an asset using a single-factor and multi-factor model
Ri = E(Ri) + Bi1(I1 - E(I1) + .. + Bik(Ik - E(Ik) + ei
Ik - E(Ik) is difference between observed and expected values of factor k
Bik is coefficient measuring effect of changes in factor Ik on rate of return on security i
Explain how to construct a portfolio to hedge exposure to multiple factors
Each factor regraded as a security so take opposite positions in factors to equal them out
Describe and apply the Fama-French three-factor model in estimating asset returns
E(R_p) - r = alpha_p + B_PM * (E(R_m) - r) + B_P,SMB * E(SMB) + B_P,HML * E(HML)
SMB means small minus big, difference between returns of small stocks and large stocks
HML means high minus low, difference between returns of stocks with high book-to-market and low book-to-market values
