Fete Section 4

Front 1

APT Assumptions

Back 1

1. The capital mkts are perfectly competitive & frictionless
2. Indiv's have homogeneous beliefs that the returns are governed by the linear k-factor model
3. The number of assets under consideration s/b much larger than the number of factor k
4. The noise term s/b the unsystematic risk component for the i-th asset
5. The noise term must be independent of all factors and all error terms for other assets

Front 2

Reasons Why the APT is much more robust than the CAPM

Back 2

1. Make no assumps about the empirical dist'n of asset returns
2. Make no strong assumps about indiv's utility fns
3. Allow the equilibrium returns of assets to depend on many factors
4. Yield a statement about the rel pricing on any subset of assets
5. No special role for the mkt portfolio
6. Be easily extended to a multiperiod framework

Front 3

Three Components of the Value of Information

Back 3

1. The utilities of the payoffs
2. The optimal actions
3. The probabilities of states of nature

Front 4

Four Hypotheses about how prices are determined

Back 4

1. Naive hypothesis
2. Speculative equilibrium hypothesis
3. Intrinsic value hypothesis
4. Rational expectations hypothesis

Front 5

CAPM Assumptions

Back 5

1. All investors are wealth maximizers
2. They can borrow/lend at rfr
3. They have no restrictions on short sales
4. They have homogeneous return expectations
5. Securities mkts are frictionless & perfectly competitive

Front 6

Three Theories of the Time-Series Behavior of Prices

Back 6

1. Fair Game
2. Martingale
3. Random Walk

Front 7

Four Empirical Models used for Residual Analysis

Back 7

1. Market Model
2. CAPM
3. Empirical Mkt Line
4. Multifactor Cross-Sectional Models

Front 8

Common Errors of Empirical Studies

Back 8

1. Biased model of equilibrium returns
2. Specification searches
3. Sample selection bias
4. Survivorship bias
5. Biased measures of return
6. Inapprop portfolio weightings
7. Failure to distinguish b/tw statistical & econometric significance
8. Overest'g the grequency of arbitrage opportunities

Front 9

Informational Asymmetry & Agency Theory

Back 9

Informational Asymmetry:
1. One group has better/more timely info than other groups
2. A signal is an action take by the more informed that provided credible info to the less informed

Agency Theory:
1. Conflicting interests btw agents & principals can lead to suboptimal allocation of resources w/in the firm

Front 10

Conflict of Interest b/tw Principals & Agents

Back 10

1. Shirking by the agent
2. Diversion of resources by the agent for private consumption
3. Differential time horizon of the agent & principal
4. Differential risk aversion of the agent & principal

Front 11

Signaling

Back 11

1. The managers of the high-qual firms signal their superiority to the mkt
2. Seperate themselves from low-qual firm as long as the low-qual firm can't mimic their actions

Front 12

Pecking Order in Financing

Back 12

1. Internal funds first
2. Risk Free debt
3. Risky Debt
4. Equity Last

Front 13

Costly vs. Costless Signaling
Exogenous & Endogenous

Back 13

Costly/Exogenous:
1. The amt of the firm's equity retained by an entepreneur
2. The amt of debt issued by the firm
3. The size of the div declared
4. The type of financing used for an investment
5. The decision to split the stock

Costless/Endogenous:
1. Stock Splits
2. The amt of equity issued or repurchased
3. The types of debt issued or repurchased

Front 14

Four Sources of Conflict b/tw Bondholders & Stockholders

Back 14

1. Div payout
2. Claim dilution
3. Asset substitution
4. Underinvestment

Front 15

The Aims of Financial Models

Back 15

1. Models are used to rank securities
2. Models are used to interpolate or extrapolate from liquid prices to illiquid prices
3. Models transform intuitive linear quantities into nonlinear dollar values

Front 16

Two Building Blocks of Behavioral Finance

Back 16

1. Limits to arbitrage
2. Psychology

Front 17

Ways that People Form beliefs in Practice

Back 17

1. Overconfidence
2. Optimism & wishful thinking
3. Representativeness
4. Conservatism
5. Belief perseverence
6. Anchoring
7. Availability biases

Front 18

Anomolies
(higher avg returns in stock mkt)

Back 18

1. Size premium - smaller size
2. Long-term reversals - "loser" portfolio
3. Predictive power of scaled ratios - higher B/M or E/P ratios
4. Momentum - "winner" portfolio
5. Earnings announcements - "good" earnings announcements
6. Div initiations & omissions - div initiations
7. Stock repurchases - stock repurchases
8. Primary & Secondary offerings - no offerings

Front 19

Investor Behavior

Back 19

1. Insufficient diversification
2. Naive diversification
3. Excessive trading
4. Selling decision
5. Buying decision

Front 20

Two Mutually Exclusive types of Randomness

Back 20

1. Mild (Guassian)
2. Wild (fractal or scalable power laws)

Front 21

Advantages of Using Fractal Approach

Back 21

1. Easy to extrapolate multiple projected scens
2. Give you a clearer idea of your risks by expressing them as a series of possibilities
3. Id a portfolio's vulnerability to severe risks