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Flashcards in Lecture 8 Deck (18)
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1
Q

Multi-factor models of security returns can be used to

A

Measure and manage the exposure to economy-wide factors

2
Q

Multi-factor models allow us

A

To describe and quantify different factors that affect the rate of return of a security in the time period

3
Q

Market return reflects

A

Macro factors and average sensitivity of firms to those factors

4
Q

When we estimate the single-index regression, we incorrectly assume

A

Each stock has the same relative sensitivity to each risk factor

5
Q

Models that can allow for several factors provide

A

Better descriptions of security returns

6
Q

The coefficients of each factor measure

A

The sensitivity of share returns to that factor (beta)

7
Q

Arbitrage price theory

A

Predicts the security market line linking expected returns to risk

8
Q

Arbitrage price theory relies on key assumptions (3)

A
  • Security returns can be described by a factor model
  • There are sufficient securities to diversify away idiosyncratic risk
  • Efficient security markets don’t allow for persistent arbitrage opportunities
9
Q

Arbitrage opportunities arise when

A

Investors can earn riskless profits without making a net investment

10
Q

Law of one price

A

If two assets are equivalent in all aspects, they should have the same market price

11
Q

Arbitrage opportunities are

A

Quickly competed away

12
Q

Arbitrage pricing theory provides (2)

A
  • Benchmark for the rates of return used in capital budgeting/ security valuation
  • Distinction between non-diversifiable risk that requires reward in the form of a risk premium, and diversifiable that doens’t
13
Q

Limitations of arbitrage pricing theory (2)

A
  • Relationship may only hold for a small number of securities
  • Cannot rule out the violation of the expected return-beta relationship for an asset
14
Q

Fama-french =

A

Alternative approach to specifying macroeconomic factors that uses firm characteristics to proxy for exposure to systematic risk

15
Q

Factors in Fama-French

A

Variables that predict the average returns well (based on past evidence) to capture risk premiums

16
Q

Small minus big (SMB)

A

Return on portfolio of small stocks in excess of the return on portfolio of large stocks

17
Q

High minus low (HML)

A

Return on portfolio of stocks with a high book to market ratio in excess of the return on a portfolio of stocks with a low book to market ratio

18
Q

Fama-French variables

A

May capture the sensitivity to risk factors in the macroeconomy