Multifactor Flashcards
elaborate on the motivation of this chapter
the motivation is the assumption that the market portfolio is not efficinet. This means, we are at a position where we dont know what to do as the CAPM is not longer accurate.
We need to figure out a way to approach this, which is what this chapter is all about
Assume the market portfolio is not efficient. What do we need to do?
We need to find a new portfolio that is effcient. Doing so will allow us to rely on the CAPM again
What is the “issue” with finding a new efficient portfolio?
Fidning such a portfolio is extremely difficult in real life, because it is next to impossible to accurately estiamtye the expected reutrn and volatility7standard deviaiton of a portfolio with great accuracy.
As a result, we need to look beyond that of the regulr tehcniques.
What do we do as a result of finding new effiecinet portfolio is extrenmely difficult?
We need to rely on certian characeteristics of an efficient portfolio. Since we know that it is hopeless to try to find it alone, we utilize 2 important characteristics:
1) The efficient portfolio is well deverisifed
2) We can create an efficinet portfolio by combining a multiple of well diversified portfolios.
Therefore, we reduce the task to finding a set of well diverisified portfolios that we can combine into a single model (single model wiht multiple factors)
What is the very important implicaiton of using a multiple of well diverisfied portfolios to find the efficient one?
We do not need to find the efficient portfolio. We can do it easier.
What is the first step in building the well diversified portfolios that will ultimately be combined into a proxy for hte efficinet portfolio?0
We assume that we have found a set of well diversified portfolios, and we refer to them as factor portfolios.
Then we take these factor portfolios, and extend the CAPM.
In addition to expected return from each portfolio, what do we need?
Factor betas. The factor betas represent important charactgeristics for each portfolio.
elaborate on the fundamental differnece between using the market portfolio only, vs using a set of various portfolios?
When we only use the market portfolio, we automatically assume that this portfolio capture ALL systematic risk. Thereby, there is no risk that is not captured here, and the CAPM result is a perfect indicator of the compensation investors should receive.
the moment we start using multiple portfolios, the assumption change. the assumption is that the market portfolio alone is not suitable at caputring the entire/all systematic risk.
NOTE: There is a key difference between systematic risk and market risk here. Market risk refer to the risk associated between single stocks and the major economic swings. This might be a fair assumption, and it also might not be. If it turns out to not be fair, then it means that there are certain risks associated with securiteis that appear as systematic and are not captured by the market. This means that there are risks that investors SHOULD be compensated for, but they are not accounted for when using the single factor CAPM. As a result, if one is able to identify the other types of systematic risks, they can understand the picutre better. This allows for a more accurate representation of whether securities are priced according to their risk level or not.
Precisely define what the APT is and entails
APT = arbitrage pricing theory.
APT basically just assumes that systematic risk consists of indivudal factors, and not a single factor like the CAPM assumes.
Here is exactly what APT is and entails:
1) Core assumption is arbitrage free markets. There exists no opportunieis because of how investors immediately adjsut prices to fit the risk levels associated with the factor model.
2) Systematic risk actually consists of multiple individual factors, and cannot be captured accurately by a single factor.
Elaborate on how APT differ from CAPM
APT assume no arbitrage. CAPM assume rational investors. These are 2 extremely different things.
APT assumes no arbitrage and that systematic risk consists of individual factors. Prices adjust to align with the factor model because investors will exploit arbitrage opportunities.
CAPM relies on rational investors, who price assets according to their exposure to a single market risk factor (beta). CAPM does not focus on arbitrage but assumes that equilibrium exists because rational investors act efficiently.
Elaborate on something that a multifactor (buolding on the general framework of APT) allows investors to do
Smart beta strategy.
Smart beta strategy refer to cases where the investor can tailor his risk exposure in a way that fits his particular risk profile. For instance, he can already be exposed to certain risks, and might not want to be exposed as much to these in new investments etc.
Perhaps also one can say that if you assume the risk is not that big for that particular factor, this give you the ability to adjust the formula to get a more “accurate” representation of the compensation you should aim for.
the multifactor model equation is fucked up looking. Is there a way to simplify it?
Yes, if we add the constraint of requirign that each factor portfolio is self financing.
picture a position that borrow funds at the risk free rate to purchase shares in a stock. The return from the stock is nice, and will partly go to paying the rate we borrowed at.
As a result, we can for instance borrow at 5%, earn 15%, and end up having 10% gain.
if we use self financing portfolios, what would the return we end up with be? The core idea is that the portfolio does not cost anything, and we only end up wiht the excess return.
IMPORTANT: In order not to double count, we must remove the less risk free rate, since this is already accounted for in the expected value for each factor portfolio.
So, therefore, as long as the portfolio is self finacning, the expected return ACCOUNTS FOR THE EXCESS RETURN.
This allows us to simplify the equation to: rf + beta x E[R1]…
Define a self financing portfolio
A portfolio where one of the parts pays for the other.
Which portfolios are included in the FFC?
Fama-French-Carhart Factor model includes 4 factors:
1) market
2) small minus big
3) high minus low
4) PR1YR
elaborate detailed on the market portfolio used in FFC
Just as normal in CAPm
