Week 6 Flashcards
Single Factor APT
a well-diversified portfolio will have very small positions in all securities. Given this:
If only one security violates the expected return-beta relationship,
the effect of this violation on a well-diversified portfolio will be too small to be of any importance, and meaningful arbitrage opportunities will not arise.
Single Factor APT
a well-diversified portfolio will have very small positions in all securities. Given this
A portfolio including many securities that violate the expected return- beta relationship
would no longer satisfy the relationship itself, meaning arbitrage opportunities would arise.
it can be concluded that the no-arbitrage condition in a single-factor security market implies
that the expected return-beta relationship must be maintained for all well-diversified portfolios and the vast majority of individual securitie
Early empiriral of CAPM suggested
non-systematic risk was significant in explaining security returns, a finding inconsistent with the CAPM
More recent empirical evidence on CAPM
More recent evidence, which controlled for error in the measurement of beta, contradicted earlier tests, finding that
finding that non-systematic risk did not explain security returns.
- However, the SML estimated in providing this evidence was too flat relative to that predicted by the CAPM; and,
- the market index outperforms the majority of professionally managed portfolios, consistent with the efficiency of the former as well as with the CAPM.
Roll argues that
the CAPM cannot be tested unless the composition of the true market portfolio is known and reflected in all tests.
- Further, he asserts that, using a proxy such as the S&P500, as most tests have done, will only provide evidence on its mean-variance efficiency, not that of the true market portfolio
Recent tests of the single index model account for human capital and cyclical variation in asset betas. These two complexities are taken into consideration as
- The CAPM assumes that all assets are traded and accessible to all investors. Despite this, an important non-traded asset known as human capital exists. Indeed, changes in this variable are far from perfectly correlated with asset returns and, therefore, acts to diversify the risk of investor portfolios; and,
There exists considerable support for the fact that asset betas vary in line with business cycles.
Empiral evidence on Single index model
Once human capital and time variation in asset betas are taken into consideration
results are far more consistent with the single-index CAPM and APT. Moreover, once these variables are accounted for, results suggest that:
Macroeconomic variables are not required to explain expected returns; and,
Anomalies including the size and book-to-market effects disappear.
With respect to the multifactor CAPM and APT
Chen, Roll and Ross provide evidence supporting the idea that good proxies for systematic factors include
The percentage change in industrial production;
The percentage change in expected inflation;
The percentage change in unanticipated inflation
The excess return of long-term corporate bonds over long-term government bonds; and,
The excess return of long-term government bonds over T-bills.
With respect to the multifactor CAPM and APT,
Fama and French argue
Fama and French argue that firm-specific factors, namely size and relative value, measure risks that are not captured by the CAPM beta but are nonetheless priced.
Opponents of this model argue that premiums for these factors represent mispricing and are the result of an irrational preference to invest in large firms and those with low book-to-market ratios.
equity premium puzzle
Research suggests that equity returns exceed the risk-free rate by an amount that is inconsistent with reasonable risk aversion levels.
equity premium puzzle. Results provided by Fama and French suggest that:
The puzzle is largely the result of excess returns earned in the last 5 decades. Moreover, returns during this period were the result of unexpected capital gains, and therefore, excess returns in the future will be small relative to those enjoyed historically; and,
Survivorship bias could also contribute to the puzzle. More specifically, an upward bias resulting from the fact that tests utilise long-term average returns from one of the strongest markets in the world, namely the US, and ignore those from other less successful markets, could exist.
Discuss the advantages of the multifactor APT over the single factor APT and the CAPM
The single factor APT and the CAPM assume that there is only one systematic risk factor affecting stock returns. However, several factors may affect stock returns. Some of these factors are: business cycles, interest rate fluctuations, inflation rates, oil prices, etc. A multifactor model can accommodate these multiple sources of risk.
Discuss the advantages of the multifactor APT over the single factor APT and the CAPM
The single factor APT and the CAPM assume that there is only one systematic risk factor affecting stock returns. However, several factors may affect stock returns. Some of these factors are: business cycles, interest rate fluctuations, inflation rates, oil prices, etc. A multifactor model can accommodate these multiple sources of risk.
One shortcoming of the multifactor APT is that
the model provides no guidance concerning the factors or risk premiums on the factor portfolios. The CAPM implies that the risk premium on the market is determined by the market’s variance and the average degree of risk aversion across investors.
Arbitrage opportunities will not exist when
the expected return of all well-diversified portfolios lie on the SML
