Multifactor models - ICAPM Flashcards
Who developed the ICAPM?
Merton (1973)
Why was the ICAPM developed?
To extend the CAPM to a multifactor framework.
Assumptions of ICAPM
- Investors have a multiperiod investment horizon
- Investors are concerned about changes in future investment opportunity set
Why are investors no longer mean-variance optimisers?
They can now invest to hedge the risk of unfavorable shifts of future investment opportunity set.
How does Fama (1996) refer to the optimal portfolio problem?
Multifactor Minimum Variance Efficiency
What does Merton(1973) show an exact linear relation between?
Expected returns and systematic risk
What captures systematic risk in the ICAPM?
Both the market beta and the bets of the S state variables
How many state variables are important for ICAPM?
The ICAPM doesn’t say how many important state variables there are or what exactly they are.
What critiques do the CAP and the ICAPM share?
The Roll critique (1977)
Practical applications of multifactor models?
- Evaluating fund performance
- Tracking indexes
- Estimating expected returns and covariance matrix
- Factor investing
How to test multifactor models?
Time-series regression
If the linear factor model is true then alpha=what?
Alpha = 0 for all assets.
Gibbons, Ross, and Shanken (1989)
What are are the average excess returns of K factors in the time-series regression approach?
The estimates of the factor risk premiums (Shanken(1992)).
Whats the best multifactor model to use?
Fama and French compare the models looking at metrics of alphas.
How to tell if one model is better than the other?
Whichever one has alphas closet to zero is better
