TOPIC 7 - MULTIPLE RISK FACTORS

Question 1

What do multifactor models seek to do?

Answer 1

improve the explanatory power of single-factor models by explicitly accounting for the various components of systematic risk (use indicators to capture wide range of macroeconomic risk factors)

Question 2

once we start allowing for multiple risk factors, we conclude that:

Answer 2

the SML ought to also be multidimensional, with exposure to each risk factor contributing to the total risk premium of the security

Question 3

A risk-free arbitrage opportunity arises when 2 or more security prices enable investors to

Answer 3

construct a zero net investment portfolio that will yield a sure profit.

Question 4

The presence of arbitrage opps will generate

Answer 4

a large volume of trades that puts pressure on security prices until prices reach levels that preclude such arbitrage.

Question 5

When securities are priced so that there are no risk-free arbitrage opportunities, we say that they

Answer 5

satisfy the no-arbitrage condition (. A situation in which all relevant assets are priced appropriately and there is no way for one’s gains to outpace market gains without taking on more risk)

Assuming an arbitrage-free condition is important in financial models, thought its existence is mainly theoretical.

Question 6

why are price relationships that satisfy the no risk-free arbitrage condition important?

Answer 6

bc we expect them to hold in real-world markets

Question 7

well diversified portfolio =

Answer 7

large no securities with sufficiently small investment proportions

Question 8

in a single factor security market, all well diversified portfolios have to satisfy

Answer 8

the expected return-beta relationship of the CAPM to satisfy the no-arbitrage condition

Question 9

the arbitrage pricing theory doesn’t require

Answer 9

the restrictive assumptions of the CAPM and its unobservable market portfolio –> but consequence of this is that the APT can’t guarantee this relationship for all securities 100% of the time

Question 10

A multifactor APT generalises

Answer 10

the single factor model to accommodate several sources of systematic risk.

Question 11

• the multi-dimensional SML predicts that exposure to each risk factor contributes to

Answer 11

the security’s total risk premium by an amount = to the factor B x risk premium of the factor portfolio that tracks that source of risk

Question 12

The multifactor extension of the single-factor CAPM, the ICAPM predicts

Answer 12

the same multidimensional security market line as the multifactor APT.

Question 13

what is arbitrage?

Answer 13

the exploitation of security mispricing in such a way that risk free profits can be earned

Question 14

what is the most basic principle of capital market theory?

Answer 14

that well-functioning security markets rule out arbitrage opportunities

Question 15

why do we generalise the SML of the CAPM?

Answer 15

to get a richer insight into the risk-return relationship –> use arbitrage pricing theory

Question 16

what do multifactor models posit?

Answer 16

that returns respond to several systematic (non diversifiable risk factors) + firm specific influences

Question 17

3 propositions the APT relies on

Answer 17

1) security returns can be described by a factor mode (1 or as many as u like)
2) there are sufficient securities to diversify away idiosyncratic risk
3) well-functioning security markets don’t allow for the persistence of arbitrage opportunities

Question 18

for the APT’s first proposition that 1) security returns can be described by a factor model, for every factor chosen it’s assumed that

Answer 18

all variance is captured by the security analysis)

–> if we don’t get factors right we could overlook substantial factors and the proposition will be defeated!!!

Question 19

Arbitrage opportunity exists when an investor can

Answer 19

earn riskless profits without making a net investment

–> requires 0 investment outlay

Question 20

The law of one price states that

Answer 20

in the absence of friction between global markets, the price for any asset will be the same.

Question 21

The law of one price is achieved by

Answer 21

eliminating price differences through arbitrage opportunities between markets.
Market equilibrium forces would eventually converge the price of the asset.

Question 22

A well-diversified portfolio is one with each weight

Answer 22

small enough that for practical purposes the non-systematic variance is negligible

Question 23

does APT assume investors are mean variance optimisers?

Answer 23

NO

Question 24

what can’t the APT rule out?

Answer 24

a violation of the expected return-beta relationship for any particular asset (to be relevant for pricing of individual assets, argues that if principles of arbitrage pricing apply to well-diversified portfolios are price such that they’re commensurate in a linear fashion to level of beta risk (sensitivity to systematic factor) on average all the assets in the portfolio have to observe that relationship too

Question 25

APT uses what sort of index?

Answer 25

an observable market index

Question 26

CAPM provides XXXX statement on expected return-beta relationship

Answer 26

Provides unequivocal statement on the expected return-beta relationship for all securities

(APT doesn’t state this but suggests certain pricing relationships ought to hold for well diversified portfolios and having established that it needs to on average hold for the individual assets within the well diversified portfolio and not necessarily for every individual asset)

Question 27

CAPM achieves equilibrium from

Answer 27

individual investors

Question 28

APT equilibrium can be

Answer 28

the actions of a few investors seizing arbitrage opportunities

Question 29

the multifactor APT states that the overall risk premium on a portfolio should =

Answer 29

sum of the risk premiums required as compensation for each source of systematic risk

(aka get the risk premium for exposure to each source of risk)

Question 30

ratio of risk premium to beta

Answer 30

E(r)/B

Question 31

why do you look at the ratio of risk premium to beta

Answer 31

to compare with assets have the highest returns for their betas –> can make a portfolio out of this and create an arbitrage opp

Question 32

if you’re calculating the expected excess return for a portfolio with investments in the rf asset, what’s the return on the rf asset?

Answer 32

it’s 0% bc the rf asset doesn’t have an excess return

Question 33

E(Rp) =

Answer 33

expected excess return = E(rp) - rf