Lecture 8 Flashcards
Multi-factor models of security returns can be used to
Measure and manage the exposure to economy-wide factors
Multi-factor models allow us
To describe and quantify different factors that affect the rate of return of a security in the time period
Market return reflects
Macro factors and average sensitivity of firms to those factors
When we estimate the single-index regression, we incorrectly assume
Each stock has the same relative sensitivity to each risk factor
Models that can allow for several factors provide
Better descriptions of security returns
The coefficients of each factor measure
The sensitivity of share returns to that factor (beta)
Arbitrage price theory
Predicts the security market line linking expected returns to risk
Arbitrage price theory relies on key assumptions (3)
- Security returns can be described by a factor model
- There are sufficient securities to diversify away idiosyncratic risk
- Efficient security markets don’t allow for persistent arbitrage opportunities
Arbitrage opportunities arise when
Investors can earn riskless profits without making a net investment
Law of one price
If two assets are equivalent in all aspects, they should have the same market price
Arbitrage opportunities are
Quickly competed away
Arbitrage pricing theory provides (2)
- Benchmark for the rates of return used in capital budgeting/ security valuation
- Distinction between non-diversifiable risk that requires reward in the form of a risk premium, and diversifiable that doens’t
Limitations of arbitrage pricing theory (2)
- Relationship may only hold for a small number of securities
- Cannot rule out the violation of the expected return-beta relationship for an asset
Fama-french =
Alternative approach to specifying macroeconomic factors that uses firm characteristics to proxy for exposure to systematic risk
Factors in Fama-French
Variables that predict the average returns well (based on past evidence) to capture risk premiums
