Finance Models: CAPM and APT Overview

To determine the expected return of an asset based on its systematic risk relative to the market.

APT allows for multiple factors affecting asset returns, while CAPM focuses solely on market risk.

The capital market is assumed to be perfect and complete, with no frictions or imperfections.

<p>Investors' risk aversion dictates their portfolio choices while homogeneous expectations ensure consistent predictions about asset returns.</p> Signup and view all the answers

<p>It refers to selecting portfolio weights that lead to the highest expected satisfaction from future wealth.</p> Signup and view all the answers

<p>The firm should invest if the expected return on the project is greater than the required rate of return calculated using CAPM.</p> Signup and view all the answers

<p>E(R e project) equals E(R e CAPM) under the condition that the project does not involve any debt.</p> Signup and view all the answers

<p>Yes, the firm should invest because 2.25% (expected return) is greater than 1.99% (required return).</p> Signup and view all the answers

<p>Transforming to an ex ante form allows practitioners to apply CAPM using actual observed data, making it relevant for real-world applications.</p> Signup and view all the answers

<p>Covariance indicates how the project return moves in relation to the market return, influencing the expected risk and return profile of the project.</p> Signup and view all the answers

<p>It represents the expected return on an asset j, accounting for the market return's excess and a random error term.</p> Signup and view all the answers

<p>The empirical version uses actual return data for analysis, rather than relying on expected returns.</p> Signup and view all the answers

<p>βj represents the sensitivity of asset j's returns to the overall market returns.</p> Signup and view all the answers

<p>It implies that there are no abnormal returns for asset j after adjusting for market risks.</p> Signup and view all the answers

<p>δmt indicates the excess return of the market over its expected value.</p> Signup and view all the answers

<p>This equation shows how the excess return of asset j over the risk-free rate is influenced by the excess return of the market and its beta.</p> Signup and view all the answers

<p>ϵjt captures the random variations in asset returns that are not explained by market movements.</p> Signup and view all the answers

<p>λ represents the market risk premium, defined as the expected market return minus the risk-free rate.</p> Signup and view all the answers

<p>Common factors and firm specific noise.</p> Signup and view all the answers

<p>$b_{ik}$ represents the sensitivity of the ith asset's returns to the k th factor.</p> Signup and view all the answers

<p>It's expressed as $\alpha_p = \sum_{i=1}^{N} w_i \alpha_i = E(R_{ep})$.</p> Signup and view all the answers

<p>$\epsilon_{ep}$ represents the unsystematic risk of the portfolio.</p> Signup and view all the answers

<p>The formula is $Var(R_{ep}) = \sum_{k=1}^{K} b_{pk}^2 Var(F_{ek}) + Var(\epsilon_{p})$.</p> Signup and view all the answers

<p>It implies that the noise terms for different assets are uncorrelated.</p> Signup and view all the answers

<p>$F_{ek}$ signifies the k th factor that is common to the returns on all assets.</p> Signup and view all the answers

<p>$\epsilon_{ei}$ represents the firm-specific risk that is unique to asset i.</p> Signup and view all the answers

<p>Systematic risk is quantified by $b_{pk} F_{ek}$, where $b_{pk}$ is the portfolio's sensitivity to the k th factor.</p> Signup and view all the answers

<p>It implies that the covariance between different factors is zero, simplifying the calculation of portfolio variance.</p> Signup and view all the answers

<p>A pure factor portfolio for factor m has a beta of 1 with respect to m and a beta of 0 with respect to all other factors.</p> Signup and view all the answers

<p>The return of a pure factor portfolio is defined as $R_{e}^{pm} = \alpha_{pm} + F_{em}$.</p> Signup and view all the answers

<p>The factor risk-premium is defined as $\lambda_{m} = E(R_{e^{pm}}) - R_{f} = \alpha_{pm} - R_{f}$.</p> Signup and view all the answers

<p>A tracking portfolio is a weighted average of pure factor portfolios and the risk-free asset, designed to have no firm-specific risk.</p> Signup and view all the answers

<p>The expected return is calculated as $E(R_{e}) = \sum_{m=1}^{K} b_{im} (\lambda_{m} + R_{f}) + (1 - \sum_{m=1}^{K} b_{im}) R_{f}$.</p> Signup and view all the answers

<p>APT operates under the assumptions of a factor model defining returns, elimination of firm-specific risk through diversification, and a perfect capital market in equilibrium.</p> Signup and view all the answers

<p>The key components are the market risk premium (bi), size premium (si), and value premium (hi).</p> Signup and view all the answers

<p>The expected return for asset i is determined by $E(R_{i}) = b_{i1} \lambda_{1} + \ldots + b_{iK} \lambda_{K} + R_{f}$.</p> Signup and view all the answers

<p>They used a cross-sectional regression approach via Fama-MacBeth method.</p> Signup and view all the answers

<p>No firm-specific risk implies that the returns are solely influenced by systematic risk factors and not by idiosyncratic risks associated with individual firms.</p> Signup and view all the answers

<p>The risk-free asset provides a baseline level of return and enables the tracking portfolio to achieve lower overall risk and different return profiles.</p> Signup and view all the answers

<p>SMB stands for 'Small Minus Big,' which measures the size premium in returns between small and large firms.</p> Signup and view all the answers

<p>In APT, the concept of no arbitrage implies that assets are correctly priced based on their risk exposures; thus, no risk-free profit can be made.</p> Signup and view all the answers

<p>HML stands for 'High Minus Low,' reflecting the value premium by comparing returns between firms with high and low book-to-market ratios.</p> Signup and view all the answers

<p>They analyzed data from July 1963 to December 1990.</p> Signup and view all the answers

<p>The debate centers around potential errors in the execution and design of empirical tests.</p> Signup and view all the answers

<p>The three directions are errors in execution, design of empirical tests, and variations among different tests.</p> Signup and view all the answers

<p>The analysis utilized daily individual stock returns from NYSE, AMEX, and NASDAQ from 1963 to 1990.</p> Signup and view all the answers