Week 4- CAPM Continued

Question 1

What are the 2 main criticisms of the CAPM?

Answer 1

• It is simple
• It has very strong assumptions

Question 2

What assumption does the zero beta or two factor model relax?

Answer 2

The assumption of riskless lending or borrowing.

Question 3

Why are there 2 different security market lines?

Answer 3

As we now have 2 CMLs to reflect that lending is cheaper than borrowing

Question 4

Do investors judge portfolios just on risk v return?

Answer 4

No, on risk v return after taxes

Question 5

What should investors whose tax bracket is below the average effective rate in the market hold?

Answer 5

A higher proportion of dividend stocks than in the market portfolio, and should hold less stocks with very low dividends.

Question 6

Under how many periods does the CAPM assume investors consider when making investment decisions?

Answer 6

1

Question 7

What assumptions are required to belive as that investors only consider one period (as in the standard CAPM)?

Answer 7

• Consumer tastes are independent of
  future events
• Consumer acts as if consumption opportunities and prices are known at the beginning of the decision period
• The consumer acts as if the distribution of one period returns on all assets are known at the beginning of the decision period.

Question 8

Theoretically, what does the CAPM tell us?

Answer 8

• Expect greater risk i.e. (a high 𝛽) ⇒ ↑return
• Linear relationship between 𝛽 and return – that is for every unit increase in 𝛽 there is the same increase in return.
• No added return for bearing non-market risk.
• From the CAPM (SML) there should be an intercept of 𝑅𝑓 and a slope of (𝑅𝑚 − 𝑅𝑓)

Question 9

What do typical investigations of the CAPM usually look at?

Answer 9

Portfolio betas

Question 10

What regression model can be used to investigate the accuracy of the CAPM? What is the unsystematic component?

Answer 10

𝑅𝑃𝑝 = 𝑎 + 𝑏(𝑅𝑃𝑚) + 𝜀𝑝 where b denotes the empirical estimate of beta. The unsystematic component is the error term

Question 11

What is the error term on a graph with a line of best fit on the CAPM regression?

Answer 11

The difference between each point and the line of best fit.

Question 12

Does empirical evidence state a positive relationship between increased beta and increased return?

Answer 12

Yes

Question 13

What do empirical findings state about the slope of the SML?

Answer 13

Empirically the SML is less steeply sloped than in theory. In other words low-beta stocks earn > return than the CAPM predicts, conversely, high-beta stocks earn < return than predicted

Question 14

What do empirical findings state about the risk-free rate

Answer 14

The intercept term is somewhat > than its theoretical counterpart 𝑅𝑓

Question 15

Do risk free investments exist?

Answer 15

No, as even on T-bills, the govt could default

Question 16

What is the Roll critque?

Answer 16

The market portfolio is often a proxy of an index, yet there are more stocks than this, so the CAPM cannot be properly tested, especially as now international diversification is more accessible

Question 17

What did Fama and French say are better predictors of future returns than beta?

Answer 17

Firm size, and ratio of book to market value (value created for shareholders
relative to the cost of creating that value)

Question 18

What did Fama and French find about beta?

Answer 18

Beta cannot explain a stock’s relative performance over time

Question 19

What is a critique of Fama and French’s paper?

Answer 19

They used annual data, and not monthly or quarterly

Question 20

Give 2 strengths of the CAPM

Answer 20

• It emphasises the likely impact of undiversifiable (market) risk upon expected returns.
• Assumes that market returns on securities relate only to the market index and other determinants are unique to individual companies and are thus diversifiable – i.e. the model is a simple one.

Question 21

Give 2 weaknesses of the CAPM

Answer 21

• Model may be too simple.
• Additional information may help explain security returns – i.e. an index of returns in the industry in which the firm operates; company size.

Question 22

Name one alternative to risk and return, what is it, and is it popular?

Answer 22

The Arbitrage Pricing Theory (APT) was developed by Ross (1976) and is essentially a generalised version of the CAPM it is more complex than CAPM, but following the critique of the CAPM by Fama and French it is more likely the APT will be used.

Question 23

If the CAPM is a theoretical model, what kind is the APT?

Answer 23

The APT is a statistical model

Question 24

Does the APT assume that investors construct an efficient portfolio? What does this mean?

Answer 24

APT doesn’t assume that investors construct an efficient portfolio
∴ don’t need strong assumptions about individuals’ utility.

Question 25

What is the equation for the simple APT in word form?

Answer 25

Expected return on asset i = Riskless return +
Sensitivity of asset i to factor i × Factor risk premium

Question 26

What is the equation for the simple APT in symbolic/letter format? What does each symbol stand for?

Answer 26

⇒ 𝐸(𝑅𝑖) = 𝑅𝑓 + 𝛽𝑖𝜆
where:𝑅𝑓 is the risk-free interest rate; 𝛽𝑖 is the systematic risk; and λ is the market price of risk.

Question 27

In the APT model, whom identifies the factor risk premium?

Answer 27

Analysts

Question 28

What is the main difference between the APT and the CAPM?

Answer 28

The CAPM specifies the systematic risk as a random return on the market portfolio, the
APT does not prespecify the systematic risk factors.

Question 29

How many risk factors can the APT incorporate, how about the CAPM?

Answer 29

The APT can be expanded to incorporate several risk factors – CAPM is restricted to one.

Question 30

Is all unsystematic risk diversified away in the APT, like it is in the CAPM?

Answer 30

No, this is not the case in the APT, and instead unsystematic risk is captured by the error term 𝜀i

Question 31

What did Chen, Roll and Ross (1986) find?

Answer 31

• Unexpected changes in industrial output;
• Unexpected changes in inflation;
• Changes in the spread between ST & LT interest rates;
• Changes in the spread of bond risk premiums.

Question 32

Explain Fama and French’s 3 factor model (1995,1997)

Answer 32

There are only 3 factors affecting return-
- Market factor – return on market index > 𝑅𝑓;
- Size factor – return on small-firm stocks > return on large-firm stocks;
- Book-to-market factor – return on high book-to-market value stocks > return on low book-to-market value stocks.

Question 33

Give a key point of the 3 point model.

Answer 33

Investors only expose themselves to such factors if they expect ↑𝐸(𝑅𝑖).

Question 34

What is the 4 step approach for estimating the APT?

Answer 34

• Identify macro risk factors
• Estimate the risk premiums
• Estimate factor sensitivities for each stock
• Calculate the expected returns

Question 35

How did empirical findings of the APT and the CAPM compare?

Answer 35

• The results found that CAPM and APT gave similar results for some industries – banking, oil & gas.
• In other industries large differences i.e. machinery & electrical equipment.

Question 36

What do the CAPM and APT both demonstrate?

Answer 36

Both the CAPM and APT tell us that unless we have a fully diversified portfolio then we will bear the unsystematic risk for which the market doesn’t compensate – therefore the key is to diversify.

Question 37

Give 2 things that financial economists agree on.

Answer 37

1) To incur ↑risk requires ↑E(R).
2) Investors are concerned predominantly with risks they cannot eliminate through diversification.

Question 38

Why should investors consider investing internationally?

Answer 38

Diversification in one country is limited due to market risk i.e. all companies are prone to the same macro shocks, whereas diversification across countries whose business cycles are not in perfect unison should enable the investor to further reduce risk.

Question 39

How is 𝛽international calculated?

Answer 39

(Correlation with UK market * standard deviation of foreign market)/ standard deviation of UK market

Question 40

Why is 𝛽international<𝛽national

Answer 40

since 𝜌(foreign stock) < 𝜌(UK stock)

Question 41

When internationally diversifying a portfolio, what happens to the EF and the SML? How about the market portfolio (assume same risk-free rate for both)

Answer 41

• They shift
• The international market portfolio has a higher returns and less risk

Question 42

Why does home bias often occur (Poterba, 1991)? What are the effects of this?

Answer 42

• Political risk
  – Foreign exchange risk
  Home bias behaviour undermines portfolios’ performance as it provides individual investors with a far from the optimal combination of portfolio return and risk.

Question 43

What is the stockholding puzzle?

Answer 43

Few households holding stocks, despite the relatively high expected returns

Question 44

What are the 2 kinds of equity portfolio management strategy

Answer 44

• Active (aiming to exceed the passive benchmark, net of transaction costs and on a risk-adjusted basis)
• Passive (eg index trackers with lower fees than active management)