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22 Cards in this Set
- Front
- Back
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CAPM is criticized because of |
The many unrealistic assumption The difficulties in selecting a proxy for the market portfolio as a benchmark |
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APT |
alternative pricing theory with fewer assumptions was developed |
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Three major assumptions |
Capital markets are perfectly competitive investors always prefer more wealth to less wealth with certainty The stochastic process generating asset returns can be expressed as a linear function of a set of K factors or indexes |
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In contrast to CAPM, APT doesnt assume |
-Normally distributed security returns -Quadratic utility function -A mean-variance efficient market portfolio |
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Arbitrage Pricing Theory |
Developed by Stephen Ross -specifies several risk factors, thereby expanding the definition of systematic investment risk compared to that implied by the CAPM's single market portfolio |
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Multiple factors include |
Inflation -Growth in GNP -Major Political upheaval -changes in interest rates |
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selecting risk factors |
-as discussion earlier the primary challenge with using the APT in security valuation is identifying the risk factor -for this illustration, assume that there are two common factors -first risk factor: unanticipated changes in the rate of inflation -second risk factor: unexpected changes in the growth rate of real GDP |
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little b's |
sensitive risk or loadings and are company specific |
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k's |
than 2 or more and is place holder |
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lamda represent |
risk premia and are not company specific |
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Arbitrage opportunity |
•Arbitrage Opportunity–Ifone “knows” actual future prices for these stocks are different from thosepreviously estimated, then these stocks are either undervalued or overvalued –Arbitragetrading (by buying undervalued stocks and short overvalued stocks) willcontinues until arbitrage opportunity disappears –Assumethe actual prices of stocks A, B, and C will be $37.20, $37.80, and $38.50 oneyear later, then arbitrage trading will lead to new current prices:E(PA)=$37.20 / (1+7.7%)=$34.54E(PB)=$37.80 / (1+5.7%)=$35.76E(PC)=$38.50 / (1+9.7%)=$35.10 |
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Roll-Ross study |
–The methodology used in the study is asfollows§Estimatethe expected returns and the factor coefficients from time-series data onindividual asset returns§Usethese estimates to test the basic cross-sectional pricing conclusion implied bythe APT
–The authors concluded that the evidencegenerally supported the APT, but acknowledged that their tests were notconclusive |
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The Multifactor Model in Theory |
In amultifactor model, the investor chooses the exact number and identity of riskfactors, while the APT model doesn’t specify either of them
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The mulifactor Model in Practice |
-Macroeconomic-Based Risk Factor Models:Risk factors are viewed as macroeconomic in nature–Microeconomic-Based Risk Factor Models:Risk factors are viewed at a microeconomic level by focusing on relevantcharacteristics of the securities themselves,
–Extensions of Characteristic-Based RiskFactor Models |
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Macroeconomic-based risk factor models |
Securityreturn are governed by a set of broad economic influences in the followingfashion by Chen, Roll, and Ross in 1986
where: Rm= thereturn on a value weighted index of NYSE-listed stocks MP=the monthly growth rate in US industrialproduction DEI=the change in inflation, measured by theUS consumer price index UI=the difference between actual and expectedlevels of inflation UPR=the unanticipated change in the bondcredit spread UTS= the unanticipated term structure shift(long term less short term RFR) |
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Macroeconomic Factors |
–Confidencerisk
–Timehorizon risk –Inflationrisk –Businesscycle risk –Markettiming risk X |
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SMB |
–(i.e. small minus big) is the return to aportfolio of small capitalization stocks less the return to a portfolio oflarge capitalization stocks |
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HML |
–HML (i.e. high minus low) is the returnto a portfolio of stocks with high ratios of book-to-market values less thereturn to a portfolio of low book-to-market value stocks
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excess return form |
(Rit-RFR) |
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Carhart |
developed the 4 factor model by including a risk factor that accounts for the tendency for firms with positive past return to produce postitive future return |
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momentum factor |
subract winner portfolio from loser portfolio |
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estimating expected returns for individual stock |
–A specificsetof K common risk factors must be identified –Therisk premia forthe factors must be estimated –Sensitivitiesof the ithstock to each of those K factors must be estimated –Theexpected returns can be calculated by combining the results of the previoussteps in the appropriate way
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