Week 3 Investment Models PDF

1. CAPM Tests: - Additional tests including squared beta and idiosyncratic risk found these factors insignificant, but the empirical Security Market Line (SML) was still too flat. - Tests adding variables like firm size and book-to-market ratio rejected CAPM, a...

1. CAPM Tests: - Additional tests including squared beta and idiosyncratic risk found these factors insignificant, but the empirical Security Market Line (SML) was still too flat. - Tests adding variables like firm size and book-to-market ratio rejected CAPM, as these factors were significant while beta was not. 2. Size and Book-to-Market Effects: - Small firms tend to earn higher returns than large firms (size effect). - High book-to-market (value) stocks tend to earn higher returns than low book-to-market (growth) stocks. - These effects have been observed in multiple countries. 3. Multifactor Models: - Developed to account for multiple risk factors beyond market risk. - Examples include GDP, interest rates, and expected inflation. 4. Arbitrage Pricing Theory (APT): - Developed by Ross (1976) as an alternative to CAPM. - Assumes returns can be described by multiple factors and no arbitrage opportunities exist. - Distinguishes between systematic (factor) risk and diversifiable idiosyncratic risk. 5. Fama-French Three-Factor Model: - Factors: market excess return, SMB (Small Minus Big), and HML (High Minus Low book-to-market). - Found to explain cross-sectional variation in returns better than CAPM. 6. Fama-French Five-Factor Model: - Adds profitability (RMW) and investment (CMA) factors to the three-factor model. 7. Limitations and Considerations: - Data-snooping concerns with empirically motivated factors. - Debate over whether these factors proxy for unknown risk factors.