Podcast
Questions and Answers
What drives the equilibrium risk premium of a market portfolio?
What drives the equilibrium risk premium of a market portfolio?
- Past performance of securities
- Market demand
- Investor confidence
- Risk of market and risk aversion of average investor (correct)
In the context of CAPM, what does the expected return-beta relationship suggest?
In the context of CAPM, what does the expected return-beta relationship suggest?
- Higher beta implies lower expected returns
- Beta is a constant value regardless of market conditions
- Security risk premiums are proportional to beta (correct)
- Expected returns are unrelated to market fluctuations
What does the Security Market Line (SML) represent in the context of CAPM?
What does the Security Market Line (SML) represent in the context of CAPM?
- The relationship between expected return and market volatility
- Expected return-beta relationship of CAPM (correct)
- Growth rates of the economy over time
- The correlation between stocks and bonds
What is considered an abnormal rate of return on a security in CAPM?
What is considered an abnormal rate of return on a security in CAPM?
How can the SML be used effectively by investors?
How can the SML be used effectively by investors?
What happens to investor behavior when risk premiums fall?
What happens to investor behavior when risk premiums fall?
What is the formula indicated for expected returns in CAPM?
What is the formula indicated for expected returns in CAPM?
What does the term 'hurdle rate' refer to in the applications of CAPM?
What does the term 'hurdle rate' refer to in the applications of CAPM?
What general impact does demand have on prices in the context of risk premiums?
What general impact does demand have on prices in the context of risk premiums?
What does the term $e_{it}$ represent in the Index Model equation?
What does the term $e_{it}$ represent in the Index Model equation?
According to the CAPM, what factor is directly related to the alpha of a security?
According to the CAPM, what factor is directly related to the alpha of a security?
In the equation $r_{it} - r_{ft} = α_i + β_i (r_{Mt} - r_{ft}) + e_{it}$, what does $α_i$ signify?
In the equation $r_{it} - r_{ft} = α_i + β_i (r_{Mt} - r_{ft}) + e_{it}$, what does $α_i$ signify?
What is the expected return equation in the Index Model?
What is the expected return equation in the Index Model?
What does $R_G$ represent in the estimation of the Index Model?
What does $R_G$ represent in the estimation of the Index Model?
According to CAPM principles, what type of risk is most significant for investors?
According to CAPM principles, what type of risk is most significant for investors?
What element does the Security Characteristic Line (SCL) plot against excess market return?
What element does the Security Characteristic Line (SCL) plot against excess market return?
Why is CAPM considered untestable as a theory?
Why is CAPM considered untestable as a theory?
What does the residual represent in the estimation of the Index Model for Google?
What does the residual represent in the estimation of the Index Model for Google?
What is the role of diversification according to CAPM principles?
What is the role of diversification according to CAPM principles?
What does the term 'required rate' in the context of the Security Characteristic Line refer to?
What does the term 'required rate' in the context of the Security Characteristic Line refer to?
What does the Capital Asset Pricing Model (CAPM) suggest about a security's required rate of return?
What does the Capital Asset Pricing Model (CAPM) suggest about a security's required rate of return?
According to CAPM, the risk premium on an individual asset is proportional to which of the following factors?
According to CAPM, the risk premium on an individual asset is proportional to which of the following factors?
What is implied by the mutual fund theorem in the context of CAPM?
What is implied by the mutual fund theorem in the context of CAPM?
Why is the market portfolio considered to be on the efficient frontier?
Why is the market portfolio considered to be on the efficient frontier?
In CAPM, the relationship between risk premium and investor’s risk aversion indicates that:
In CAPM, the relationship between risk premium and investor’s risk aversion indicates that:
What aspect does beta measure in the context of a security within CAPM?
What aspect does beta measure in the context of a security within CAPM?
If all investors choose to hold the market portfolio, what is the implication for market efficiency?
If all investors choose to hold the market portfolio, what is the implication for market efficiency?
What role does variance play in calculating the risk premium on the market portfolio?
What role does variance play in calculating the risk premium on the market portfolio?
What is the main criticism of following an active investment strategy outlined in the CAPM framework?
What is the main criticism of following an active investment strategy outlined in the CAPM framework?
The efficient frontier illustrates which of the following?
The efficient frontier illustrates which of the following?
What does the formula $𝑅𝑖𝑡 = α𝑖 + β𝑖𝑀 𝑅𝑀𝑡 + β𝑖𝑇𝐵 𝑅𝑇𝐵𝑡 + 𝑒𝑖𝑡$ represent in multifactor models?
What does the formula $𝑅𝑖𝑡 = α𝑖 + β𝑖𝑀 𝑅𝑀𝑡 + β𝑖𝑇𝐵 𝑅𝑇𝐵𝑡 + 𝑒𝑖𝑡$ represent in multifactor models?
In the Fama-French Three-Factor Model, which of the following is NOT a factor used?
In the Fama-French Three-Factor Model, which of the following is NOT a factor used?
What does a higher adjusted R-square indicate in the context of multifactor models?
What does a higher adjusted R-square indicate in the context of multifactor models?
What is the main principle behind Arbitrage Pricing Theory (APT)?
What is the main principle behind Arbitrage Pricing Theory (APT)?
What is the expected return formula for a well-diversified portfolio according to APT?
What is the expected return formula for a well-diversified portfolio according to APT?
Which component represents nonsystematic risk in multifactor models?
Which component represents nonsystematic risk in multifactor models?
Which of the following statements about well-diversified portfolios is true?
Which of the following statements about well-diversified portfolios is true?
In the context of the APT, what does an arbitrage portfolio entail?
In the context of the APT, what does an arbitrage portfolio entail?
What characteristic distinguishes the multifactor model equation $𝑟𝐺 − 𝑟𝑓 = α𝐺 + β𝑀 𝑟𝑀 − 𝑟𝑓 + β𝐻𝑀𝐿 𝑟𝐻𝑀𝐿 + β𝑆𝑀𝐵 𝑟𝑆𝑀𝐵 + 𝑒𝐺$?
What characteristic distinguishes the multifactor model equation $𝑟𝐺 − 𝑟𝑓 = α𝐺 + β𝑀 𝑟𝑀 − 𝑟𝑓 + β𝐻𝑀𝐿 𝑟𝐻𝑀𝐿 + β𝑆𝑀𝐵 𝑟𝑆𝑀𝐵 + 𝑒𝐺$?
What does the variable $eta_{iT B}$ represent in the multifactor model equations?
What does the variable $eta_{iT B}$ represent in the multifactor model equations?
Flashcards
Capital Asset Pricing Model (CAPM)
Capital Asset Pricing Model (CAPM)
A model that describes the relationship between the expected return of a security and its systematic risk measured by beta.
Systematic risk
Systematic risk
The portion of a security’s total risk that cannot be diversified away. It is measured by beta.
Beta
Beta
A measure of a security's volatility relative to the market. A beta of 1 means the security moves in line with the market, while a beta greater than 1 indicates higher volatility.
Market Portfolio
Market Portfolio
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Mutual Fund Theorem
Mutual Fund Theorem
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Passive Strategy
Passive Strategy
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Market Risk Premium
Market Risk Premium
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Risk-free rate
Risk-free rate
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Efficient Frontier
Efficient Frontier
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Capital Market Line (CML)
Capital Market Line (CML)
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Risk Premium of Market Portfolio
Risk Premium of Market Portfolio
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Expected Returns on Individual Securities
Expected Returns on Individual Securities
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The Security Market Line (SML)
The Security Market Line (SML)
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Alpha
Alpha
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Applications of CAPM
Applications of CAPM
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Index Model Equation
Index Model Equation
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Alpha (α) in Index Model
Alpha (α) in Index Model
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Beta (β) in Index Model
Beta (β) in Index Model
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Index Return (rM) in Index Model
Index Return (rM) in Index Model
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Risk-free rate (rf) in Index Model
Risk-free rate (rf) in Index Model
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Firm-specific effects (eit) in Index Model
Firm-specific effects (eit) in Index Model
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Security Characteristic Line (SCL)
Security Characteristic Line (SCL)
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Residual in Index Model
Residual in Index Model
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CAPM's Assumption of Market Efficiency
CAPM's Assumption of Market Efficiency
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CAPM's Implications for Diversification
CAPM's Implications for Diversification
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Multifactor models
Multifactor models
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Two-factor SML
Two-factor SML
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Fama-French Three-Factor Model
Fama-French Three-Factor Model
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Arbitrage
Arbitrage
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Arbitrage Pricing Theory (APT)
Arbitrage Pricing Theory (APT)
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Arbitrage Portfolio
Arbitrage Portfolio
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Returns on Well-diversified Portfolio
Returns on Well-diversified Portfolio
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Beta (β)
Beta (β)
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Adjusted R-square
Adjusted R-square
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Residual Standard Deviation
Residual Standard Deviation
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Study Notes
Chapter 7: CAPM and APT
- This chapter covers the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT).
- CAPM describes the relationship between a security's required rate of return and its systematic risk (beta).
- APT describes risk-return relationships from no-arbitrage considerations in large capital markets.
7.1 The Capital Asset Pricing Model
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Capital Asset Pricing Model (CAPM): A security's required rate of return is related to its systematic risk, measured by beta.
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Market Portfolio (M): Each security is held in proportion to its market value.
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Hypothetical Equilibrium: All investors choose to hold the market portfolio.
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The market portfolio is on the efficient frontier, representing the optimal risky portfolio.
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Risk premium on the market portfolio is proportional to the variance of the market portfolio and investor risk aversion.
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Risk premium on individual assets is proportional to the risk premium on the market portfolio and proportional to the beta coefficient of the security on the market portfolio.
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The Security Market Line (SML) represents the expected return-beta relationship of CAPM.
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SML graphs individual asset risk premiums as a function of asset risk.
- Alpha represents abnormal rate of return on security in excess of what's predicted by CAPM.
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Passive Strategy is Efficient: All investors desire the same portfolio of risky assets and can be satisfied with a single mutual fund composed of that portfolio.
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If passive strategy is costless and efficient, why follow active strategy?
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If no-one does security analysis, what brings about efficiency of market portfolio?
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Risk Premium of Market Portfolio: Demand drives prices and lowers expected rate of return/risk premiums. When premiums fall, investors move funds into risk-free assets. The equilibrium risk premium of the market portfolio is proportional to the risk of market and risk aversion of average investor.
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Expected Returns on Individual Securities: Expected return-beta relationship. Implication of CAPM: security risk premiums (expected excess returns) will be proportional to beta. E(ri) = rf+ beta (E(rm)-rf)
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The Security Market Line (SML) represents the expected return-beta relationship of CAPM.
7.2 CAPM and Index Models
- Index Model, Realized Returns, Mean-Beta Equation: rit - rft = ai + Bi(rmt -rft) + eit
- rit: Holding Period Return
- i: Asset
- t: Period
- ai: Intercept of the security characteristic line.
- β₁: Slope of the security characteristic line.
- rm: Index return
- eit: Firm-specific effects
- Estimation Index Model: RGt = αG + βGRMt + eGt ; RG = rg – rf, residual = actual return – predicted return
- Security Characteristic Line (SCL): Plot of security's expected excess return over risk-free rate as a function of excess return on market. Required rate = Risk-free rate + Beta x Expected excess return of index.
7.3 CAPM and the Real World
- CAPM is false based on validity of its assumptions but is a useful predictor of expected returns.
- It is untestable as a theory. However, its principles are still valid.
- Investors should diversify.
- Systematic risk is the risk that matters.
- A well-diversified risky portfolio is suitable for a wide range of investors.
7.4 Multifactor Models and CAPM
- Multifactor models: Models of security returns that respond to several systematic factors.
- Two-index portfolio in realized returns: Rit = ai + BiMRMt + BiTBRTBt + eit
- Two-factor SML: E(ri) = rf + βim [E(rm) – rf] + BiTв[E(rтв) – rf]
- Fama-French Three-Factor Model: rG – rf = ag + βM(rm – rf) + βHMLHML + βSMB SMB + eG
- Estimation results: Three aspects of successful specification: Higher adjusted R-squared, Lower residual SD, Smaller value of alpha. Tabulated estimates are available.
7.5 Arbitrage Pricing Theory
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Arbitrage: Relative mispricing creates riskless profit.
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Arbitrage Pricing Theory (APT): Risk-return relationships from no-arbitrage considerations in large capital markets.
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Well-diversified portfolio: Nonsystematic risk is negligible.
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Arbitrage portfolio: Positive return, zero-net-investment, and risk-free portfolio.
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Calculating APT: rp = rf + Bp(rm – rf) + ep where Bp is the sensitivity to the market portfolio and ep is the firm-specific risk.
- Returns on well-diversified portfolio: E(rp) = rf + βp[E(rm)-rf]
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Multifactor Generalization of APT and CAPM: Factor portfolio, Well-diversified portfolio constructed to have beta of 1.0 on one factor and zero on any other factor, Two-factor Model for APT: R₁ = α₁ + β₁₁RM1 + β₁₂RM2 + e₁.
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Description
This chapter explores key financial concepts: the Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT). Understand how CAPM relates a security's return to its systematic risk and how APT analyzes risk-return relationships in capital markets. Dive into the implications of the market portfolio and risk premiums.
