Week 4- CAPM Continued Flashcards
What are the 2 main criticisms of the CAPM?
- It is simple
- It has very strong assumptions
What assumption does the zero beta or two factor model relax?
The assumption of riskless lending or borrowing.
Why are there 2 different security market lines?
As we now have 2 CMLs to reflect that lending is cheaper than borrowing
Do investors judge portfolios just on risk v return?
No, on risk v return after taxes
What should investors whose tax bracket is below the average effective rate in the market hold?
A higher proportion of dividend stocks than in the market portfolio, and should hold less stocks with very low dividends.
Under how many periods does the CAPM assume investors consider when making investment decisions?
1
What assumptions are required to belive as that investors only consider one period (as in the standard CAPM)?
- 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.
Theoretically, what does the CAPM tell us?
- 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)
What do typical investigations of the CAPM usually look at?
Portfolio betas
What regression model can be used to investigate the accuracy of the CAPM? What is the unsystematic component?
𝑅𝑃𝑝 = 𝑎 + 𝑏(𝑅𝑃𝑚) + 𝜀𝑝 where b denotes the empirical estimate of beta. The unsystematic component is the error term
What is the error term on a graph with a line of best fit on the CAPM regression?
The difference between each point and the line of best fit.
Does empirical evidence state a positive relationship between increased beta and increased return?
Yes
What do empirical findings state about the slope of the SML?
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
What do empirical findings state about the risk-free rate
The intercept term is somewhat > than its theoretical counterpart 𝑅𝑓
Do risk free investments exist?
No, as even on T-bills, the govt could default
What is the Roll critque?
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
What did Fama and French say are better predictors of future returns than beta?
Firm size, and ratio of book to market value (value created for shareholders
relative to the cost of creating that value)
What did Fama and French find about beta?
Beta cannot explain a stock’s relative performance over time
What is a critique of Fama and French’s paper?
They used annual data, and not monthly or quarterly
Give 2 strengths of the CAPM
- 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.
Give 2 weaknesses of the CAPM
- 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.
Name one alternative to risk and return, what is it, and is it popular?
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.
If the CAPM is a theoretical model, what kind is the APT?
The APT is a statistical model
Does the APT assume that investors construct an efficient portfolio? What does this mean?
APT doesn’t assume that investors construct an efficient portfolio
∴ don’t need strong assumptions about individuals’ utility.
What is the equation for the simple APT in word form?
Expected return on asset i = Riskless return +
Sensitivity of asset i to factor i × Factor risk premium
What is the equation for the simple APT in symbolic/letter format? What does each symbol stand for?
⇒ 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.
In the APT model, whom identifies the factor risk premium?
Analysts
What is the main difference between the APT and the CAPM?
The CAPM specifies the systematic risk as a random return on the market portfolio, the
APT does not prespecify the systematic risk factors.
How many risk factors can the APT incorporate, how about the CAPM?
The APT can be expanded to incorporate several risk factors – CAPM is restricted to one.
Is all unsystematic risk diversified away in the APT, like it is in the CAPM?
No, this is not the case in the APT, and instead unsystematic risk is captured by the error term 𝜀i
What did Chen, Roll and Ross (1986) find?
- 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.
Explain Fama and French’s 3 factor model (1995,1997)
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.
Give a key point of the 3 point model.
Investors only expose themselves to such factors if they expect ↑𝐸(𝑅𝑖).
What is the 4 step approach for estimating the APT?
- Identify macro risk factors
- Estimate the risk premiums
- Estimate factor sensitivities for each stock
- Calculate the expected returns
How did empirical findings of the APT and the CAPM compare?
- 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.
What do the CAPM and APT both demonstrate?
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.
Give 2 things that financial economists agree on.
1) To incur ↑risk requires ↑E(R).
2) Investors are concerned predominantly with risks they cannot eliminate through diversification.
Why should investors consider investing internationally?
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.
How is 𝛽international calculated?
(Correlation with UK market * standard deviation of foreign market)/ standard deviation of UK market
Why is 𝛽international<𝛽national
since 𝜌(foreign stock) < 𝜌(UK stock)
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)
- They shift
- The international market portfolio has a higher returns and less risk
Why does home bias often occur (Poterba, 1991)? What are the effects of this?
- 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.
What is the stockholding puzzle?
Few households holding stocks, despite the relatively high expected returns
What are the 2 kinds of equity portfolio management strategy
- 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)
