Michaelmas Term - Lecture 2

Question 1

Where does the capital market line lie?

Answer 1

On the efficient frontier

Question 2

What is idiosyncratic risk?

Answer 2

This is firm specific risk that we often assumed is diversified away

Question 3

How do we interpret a regression equation?

Answer 3

Y = a + bx

• a is the return if the market doesn’t move
• b is the return for every 1% change in the market

Question 4

What are the two ways of testing the CAPM? How are they different?

Answer 4

The two ways of testing the CAPM are the time-series approach and the Fame-Macbeth approach.

The time-series approach measures stocks over time. We look at t-statistics to examine whether to reject the CAPM. Usually, when the t-statistic is greater than 2 then it is significant and we reject the CAPM.

The Fama-Macbeth approach examines the CAPM cross-sectionally without looking at time periods of fixed stocks.

Question 5

What are the advantages and disadvantages of the two tests of the CAPM?

Answer 5

Time-series:
Pro - Better statistical properties

Con - Not many assets can be considered at once

Fama-Macbeth:
Pro - a) FM can include non-traded factors; b) can allow for time-varying number of firms; c) can estimate the risk premium associated with the factor

Con - No clear theoretical motivation for use