Week 5 Flashcards
When does the arbitrage pricing theory occur?
The arbitrage pricing theory occurs when an investory can create a zero risk portfolio (0 beta) with greater returns than the risk free rate. This portfolio is known as a zero investment portfolio. If markets are efficient, then these profitable arbitrage opportunities will quickly disappear.
What is alpha?
The difference between the expected return and the CAPM expected return.
Expected return-CAPM.
How can we generate a portfolio with a beta of 0?
We can have negative asset weights by short selling assets. This allows us to get a negative beta, which can be used with positive betas to get a beta of 0.
What does the asset pricing theory/arbitrage pricing theory apply to?
Well diversified portfolios, but not necessarily to individual stocks like CAPM can. It is less restrictive than CAPM.
What does the asset pricing theory at equilibrium mean for arbitrage opportunities? How does CAPM relate?
At equilibrium there will be no arbitrage opportunities. This equilibrium will be quickly restored even if only a few investors find the opportunity.
CAPM instead requires many small investors to restore the CAPM equilibrium.
What do multifactor pricing models do?
Multifactor pricing models use more than one factor in addition to market return to estimate a beta.
What does the Fama-French 3 factor model include? What about the 5 factor model?
Market index excess return (return of market - risk free), the ratio of book value of equity to market value of equity, and the firm size. The five factor model includes the three factor model, the operating margin profit, and investment policies.
What are the objectives of performance evaluation? What is generally needed?
Performance evaluation asks whether the returns worth the risk and fees.
This will depend on what we are trying to do. For passive management we want a diversified portfolio with no security mispricing identification. Active management involves forecasting broad markets and/or identifying mispriced securities to achieve higher returns. Market timing uses relative performance of risky portfolio and cash to drive fund movement.
Why is average return by itself not a good measure?
We also need a measure of abnormal performance, because we could earn higher returns with more risk, and much of the return is actually based on the market at the time. As such we need a measure that incorporates risk, and shows the result is not just from chance.
How can we measure abnormal performance?
- Group comparison, take many portfolios with the same performance style, then compare our portfolio to these styles, this can still be misleading as similar investment styles do not mean similar risk profiles.
- Use several risk adjusted measures to rank different portfolios, like the Sharpe ratio, Treynor ratio, and Jensen’s alpha.
What is the historical Sharpe ratio?
The average portfolio excess return divided by the portfolio standard deviation, the higher this ratio the better the return per risk.
What is the Treynor ratio?
The ratio of average excess return over portfolio beta, a higher value is bette.
What is Jensen’s alpha?
The difference between average portfolio return and the expected portfolio return according to CAPM. We should make sure to look at the t-statistic of the alpha value
Are the Treynor ratio, Sharpe ratio, and Jensen’s alpha consistent?
No, the Sharpe ratio is based on the risk premium, while Treynor’s is based on systematic risk. The rankings should be similar in a really well diversified portfolio
