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 π½) β βreturn
- Linear relationship between π½ and return β that is for every unit increase in π½ 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 π π and a slope of (π π β π π)
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?
π ππ = π + π(π ππ) + ππ 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 π π
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 stockβs relative performance over time
What is a critique of Fama and Frenchβs 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 β 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 β 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 doesnβt assume that investors construct an efficient portfolio
β΄ donβt need strong assumptions about individualsβ utility.