Lecture 2 Flashcards
Strategic asset allocation
Determine the long-term asset mix
- -> Depends on investment objective
- -> Define variables of a portfolio and optimize them
Main issues with the Markowitz model
Assumption: Investor knows expected value and var of returns
- -> Historical returns are poor proxies for future returns
- -> Solution: Find a model that captures expected returns
Markowitz portfolio optimization model
All portfolios are on the minimum variance frontier (upwards from minimum variance portfolio)
Search CAL with highest record-to-variability (slope)
CAPM
Equilibrium model derived using principles of diversification
Assumptions: Homo Oeconomicus, only Markowitz optimization, Price takers, no information edge, no frictions
Equilibrium conditions: All investors hold rf + Mp
CAPM describes
All individuals are: mean variance optimizers, have homogeneous expectations
All markets have: all assets publicly, all information, no frictions
Liquidity and the CAPM
Illiquidity Premium: Discount from market value to obtain quick sale (Bid-Ask Spread)
Liquidity Risk: Unexpected dry up in liquidity (high correlation between stocks)
Roll’s critique
Market Portfolio unobservable
No portfolio to test wether it is mean variance efficient
Main issues of CAPM
Many assumptions
empirically very poor performance
APT
Determining asset value based on Law of one price (no arbitrage)
Only few assumptions: All securities have values (and var), some agents form well diversified portfolios, no taxes & transaction costs
APT vs. CAPM
APT is derived from a statistical model, CAPM from an equilibrium model
CAPM: based on unobservable market portfolio, and mean variance efficiency
APT: LOOP, uses observable market index, no mean variance optimizers
Fama French Type Factor model
R = a + bRm + bSMB + b*HML + e
Size & Book to market ratios explain return on securities
High Book-to-market + small firms experience higher returns.
–> Quantifies risk premium
4 factor model with momentum
