SFM, SIM, CAPM Flashcards
What is the SFM?
The Single Factor Model shows us how stock returns are influenced by economics factors. It assumes that a single macroeconomic factor summarises systematic risk and all remaining variation is due to firm specific risk.
What is the SIM?
The Single Index Model assumes that the return on any stock depends on one common factor: the market index.
What is the link between SIM and Markowitz?
SIM is used in Markowitz MPT as calculating the efficient frontier requires too many estimates
What are the advantages of SIM?
Reduces number of estimates as we only estimate alpha, beta and firm-specific variance for each stock. We only look at one correlation.
Easier optimisation as investors can focus on selecting high beta for high risk or low beta for low risk portfolios
Explains the bulk of stock movement as market movements explain 70-90% of stock variation
What are the disadvantages of SIM?
Assumes only one factor affects returns thus making it too simplistic but in fact industry and sector specific shocks exist.
Assumes firm-specific risks are uncorrelated
Ignores negative correlation between stocks
What is diversification in SIM?
As you add more stocks to a portfolio, firm-specific risks cancel out but only leave systematic risk, thus justifying index investing
What does CAPM show us?
The Capital Asset Pricing Model describes the theoretical relationship between the risk of assets and their expected returns
What does CAPM assume?
Many individuals with small individual wealth who are price takers
Investors plan for only one holding period
Only publicly traded financial assets
No transaction costs or taxes
All investors use Markowitz’s model to max return per unit of risk
What are the implications of CAPM?
If everyone uses the same MArkowitz framework they dervie the same efficient frontier and hold the same portfolio.
Also, passive investment is efficient
What is the link CAPM say about RP?
It says that RP is driven by an assets systematic risk.
Beta x Market RP
What is the SML?
The security market line shows us the relationship between Beta and expected returns. It graphs the individual asset’s risk premiums as a function of their risk
How does the price of an asset effect its place on the SML?
If fairly priced then its on the SML
If underpriced then its above
If overpriced then its below
What is the CML?
The Capital Market Line graphs the risk premium of efficient portfolios as a function of the standard deviation
What are the two methods used to test the CAPM?
Cross-sectional regression
Time-series tests
What is cross-sectional regression and how is it done?
It test the relationship between expected returns and Beta and also tests the intercept term. The test is done by taking regression of average asset returns as an estimate of market betas. If CAPM true then alpha = risk-free rate and y = beta premium
What are the issues with cross-sectional regression and how to overcome them?
Estimates market beta which is subject to errors when calculating. This can be overcome by researchers studying portfolios instead of individual stocks
Statistical problems with correlated error terms and can be overcome by the Fama- French 3-Factor Model which adds size and value to CAPM as it reduces omitted variable bias
What is the Time-series tests
They test whether CAPM correctly explains asset returns overtime and if CAPM is true the estimated intercept should equal 0
What are the modern issues with CAPM?
Beta instability - Beta varies over time and is affected by economic conditions which the model doesn’t account for
Market portfolio proxy problem - true market portfolio is unobservable making CAPM untestable
