Multifactor models and arbitrage pricing theory Flashcards
What is a key assumption of CAPM that does not hold in reality?
Assumes a perfect financial market, which does not exist.
What is the issue with CAPM’s assumption about risk-free borrowing?
Assumes unlimited borrowing and lending at the same risk-free rate for all investors, but real-world investors cannot borrow at the government rate.
Why is the market return a problem in CAPM?
The return of the market is not a proper representation of all systematic risk factors.
Why was APT developed?
To correct CAPM’s drawbacks by considering multiple risk factors instead of just beta.
How does APT differ from CAPM?
APT is a multi-factor model, meaning it accounts for multiple sources of risk beyond market beta.
What does APT assume about expected returns?
Expected return of an asset is related to its exposure to several risk factors.
Why is APT considered more flexible than CAPM?
It has fewer restrictive assumptions, such as not requiring a market portfolio or risk-free borrowing.
How does the Single Index Model (SIM) represent systematic risk?
It summarizes systematic risk using the market return as a proxy.
How does a multi-factor model improve on SIM?
: It decomposes systematic risk into multiple dimensions instead of relying on a single market return
When does an arbitrage opportunity arise?
When an investor can earn riskless profits without making a net investment.
What does the Law of One Price (LOOP) state?
If two assets are identical in economic terms, they must have the same price.
What happens when LOOP does not hold?
Arbitrageurs exploit price differences through arbitrage.
Why is arbitrage so powerful?
Since it is riskless, investors will try to take an infinite position in it.
What is similar between CAPM and APT?
Both predict a Security Market Line (SML) linking expected returns to risk.
What are the three key propositions of APTM?
- Security returns can be described by multi-factor models.
- Firm-specific risk can be diversified away.
- Well-functioning markets eliminate arbitrage opportunities.
What does APTM state about financial asset prices?
Prices must reflect multiple key risk factors.
What must hold in a well-diversified APT portfolio?
- Requires no net investment (weights sum to zero).
- No risk (weighted sum of betas is zero).
- No arbitrage opportunities (expected return is zero).
What does APTM predict about diversified portfolios with the same beta?
They must lie on the same Security Market Line (SML).
What happens if a security is fairly priced under APTM?
It must lie on the APT Security Market Line.
What does APTM not assume that CAPM does?
- The existence of a market portfolio (M).
- Risk-free borrowing and lending availability.
What does APTM assume that CAPM does not?
- A well-diversified portfolio can be created.
- Arbitrage opportunities can be exploited without needing capital.
- A small number of arbitrageurs can clear markets of mispricing
How are stocks grouped to test APTM?
- By size – Small vs. big companies (SMB: Small Minus Big).
- By book-to-market ratio – High, medium, and low (HML: High Minus Low).
What does SMB represent?
The risk premium associated with firm size
What does HML represent?
The risk premium for book-to-market value.
