S1 - asset pricing models Flashcards
what is diversification in stock portfolios
Firm specific v systematic risk
firm specific risks for each stock will average out and be diversified
Systematic risk will affect all firms and will not be diversified
what is risk premium
for diversifiable risk is 0
Investors are not compensated for holding firm specific risk
Determined by its systematic risk and does not depend on its diversifiable risk
No arbitrage - the risk premium of a security is determined by its systematic risk and does not depend on its diversifiable risk
what is the capital asset pricing model
predicting equilibrium return
Links systematic risk and expected return
Estimates required return on equity for a given level of systematic risk
Return that shareholders require
An input to the cost of capital
what is market or systematic risk
sensitivity of a company or portfolios returns to market movements - beta
If the company/portfolio has β > 1 (β < 1), movement in price is more (less) extreme than market
The market portfolio is a portfolio of all stocks so its bm = 1
The risk free asset returns do not move with the market returns – so the brf = 0
what is the security market line
gives the equilibrium relationship between risk and return
linear relationship between a stocks beta and its expected return
Graphed as the line through the risk free investment and the market
According to CAPM, if the expected return and beta for individual securities are plotted, they should all fall along the SML
weighted average beta of the securities in the portfolio
when is the CAPM used in practice
In practice the SML is used to estimate the expected return on equity:
rf is estimated from the return on Treasury Bills or government bonds
rm is based on the return on a market index (such as FTSE100)
Market risk premiums over time have tended to average at around 6-7%
bE is estimated by regressing the company returns on the market return, called the Market Model
where is the CAPM used
Companies use CAPM to determine the required return on equity
Industry regulators use CAPM to determine the return on equity, which is an input in the determination of maximum price increases
Analysts use CAPM to explore the risk/return relationship for stocks
what are the criticisms of CAPM
Return is related to b but the slope of the line is flatter than CAPM would predict – e.g. evidence for 1931-1961 in the USA (Black, 1993)
Defenders of CAPM say it’s concerned with expected returns whereas we observe only actual returns which contain a lot of ‘noise’ or surprise elements
It’s impossible to test as the market portfolio should contain all risky investments, including stocks, bonds, commodities, real estate, paintings, human capital…
Market indices (used as a proxy) only contain a sample of common stocks.
return is related to other measures
what is arbitrage pricing theory
It arose out of dissatisfaction with the CAPM, particularly over the inability to specify the market portfolio (which should be all risky assets, whether traded or not).
Main Points:
The APT model doesn‘t ask which portfolios are efficient
It assumes that each stock’s return depends partly on:
economic influences or factors; and
‘noise’ – events that are unique to the company
what is the APT model
Return = rf + b1.(return factor 1) + b2.(return factor 2) + + noise
For any share, there are two sources of risk:
risk from the macroeconomic factors (not eliminated)
risk from events that are unique to the company (diversified away)
what is expected risk premium
The risk premium on a share depends upon the risk premium associated with each factor and the share’s sensitivity to the factors:
if you plug in a value of zero for the sensitivity (b) toeach factor, the risk premium is zero.
A portfolio that is constructed to have zero sensitivity to each factor should earn the risk free rate of interest – otherwise there are arbitrage opportunities.
The APT model assumes that any such opportunities are eliminated
criticism of APT
The theory doesn‘t say what the factors are. Statistical analysis must be performed to try to judge what they might be. Different research studies have for example identified the following possibilities: GDP, inflation, exchange rates, market and size. However, there is no consensus
what are similarities and differences between CAPM and APT
Similarity:
Expected return depends upon risk stemming from economy wide influences is not affected by unique risk
Differences
There is only one determinant factor for return in CAPM (return on market)
PT model can have any number of factors, and they are not specified in advance. Statistical analysis must be done to try to work out what these factors might be.
what is the Fama French three factor model
Fama and French (1995) found that shares of small firms and those with high book to market ratios have provided above average returns. These could be important factors that are left out of the CAPM.
If investors do demand higher returns for exposure to these factors, then we can write an equation for return that looks like the APT
explain the fama French equation
b is the sensitivity to the factor – which will vary between companies
rRP is the risk premium on the factor – which is constant across companies (but not necessarily across time)
Factor 1: The return on the market index minus the risk-free return
Factor 2: The return on a portfolio of “small” stocks minus the return on a portfolio of “large” stocks
Factor 3: The return on a portfolio of “value” stocks minus the return on a portfolio of “growth” stocks
