Week 6 Flashcards Preview

Investments > Week 6 > Flashcards

Flashcards in Week 6 Deck (31)
Loading flashcards...
1

Single Factor APT

a well-diversified portfolio will have very small positions in all securities. Given this:

 If only one security violates the expected return-beta relationship,

the effect of this violation on a well-diversified portfolio will be too small to be of any importance, and meaningful arbitrage opportunities will not arise.

2

Single Factor APT 

a well-diversified portfolio will have very small positions in all securities. Given this

A portfolio including many securities that violate the expected return- beta relationship

would no longer satisfy the relationship itself, meaning arbitrage opportunities would arise.

3

it can be concluded that the no-arbitrage condition in a single-factor security market implies 

 

 

that the expected return-beta relationship must be maintained for all well-diversified portfolios and the vast majority of individual securitie

4

Early empiriral of CAPM suggested 

non-systematic risk was significant in explaining security returns, a finding inconsistent with the CAPM 

5

More recent empirical evidence on CAPM

More recent evidence, which controlled for error in the measurement of beta, contradicted earlier tests, finding that

finding that non-systematic risk did not explain security returns.

  • However, the SML estimated in providing this evidence was too flat relative to that predicted by the CAPM; and,
  • the market index outperforms the majority of professionally managed portfolios, consistent with the efficiency of the former as well as with the CAPM. 

6

Roll argues that

the CAPM cannot be tested unless the composition of the true market portfolio is known and reflected in all tests.

  • Further, he asserts that, using a proxy such as the S&P500, as most tests have done, will only provide evidence on its mean-variance efficiency, not that of the true market portfolio

7

Recent tests of the single index model account for human capital and cyclical variation in asset betas. These two complexities are taken into consideration as 

  • The CAPM assumes that all assets are traded and accessible to all investors. Despite this, an important non-traded asset known as human capital exists. Indeed, changes in this variable are far from perfectly correlated with asset returns and, therefore, acts to diversify the risk of investor portfolios; and,

 There exists considerable support for the fact that asset betas vary in line with business cycles. 

8

Empiral evidence on Single index model

Once human capital and time variation in asset betas are taken into consideration

results are far more consistent with the single-index CAPM and APT. Moreover, once these variables are accounted for, results suggest that:

 Macroeconomic variables are not required to explain expected returns; and,

Anomalies including the size and book-to-market effects disappear. 

9

With respect to the multifactor CAPM and APT 

Chen, Roll and Ross provide evidence supporting the idea that good proxies for systematic factors include 

  The percentage change in industrial production;

  The percentage change in expected inflation;

  The percentage change in unanticipated inflation

  The excess return of long-term corporate bonds over long-term government bonds; and,

  The excess return of long-term government bonds over T-bills. 

10

With respect to the multifactor CAPM and APT, 

 Fama and French argue 

Fama and French argue that firm-specific factors, namely size and relative value, measure risks that are not captured by the CAPM beta but are nonetheless priced.

Opponents of this model argue that premiums for these factors represent mispricing and are the result of an irrational preference to invest in large firms and those with low book-to-market ratios. 

11

equity premium puzzle 

Research suggests that equity returns exceed the risk-free rate by an amount that is inconsistent with reasonable risk aversion levels. 

12

equity premium puzzle. Results provided by Fama and French suggest that: 

The puzzle is largely the result of excess returns earned in the last 5 decades. Moreover, returns during this period were the result of unexpected capital gains, and therefore, excess returns in the future will be small relative to those enjoyed historically; and,

  Survivorship bias could also contribute to the puzzle. More specifically, an upward bias resulting from the fact that tests utilise long-term average returns from one of the strongest markets in the world, namely the US, and ignore those from other less successful markets, could exist. 

13

Discuss the advantages of the multifactor APT over the single factor APT and the CAPM

The single factor APT and the CAPM assume that there is only one systematic risk factor affecting stock returns. However, several factors may affect stock returns. Some of these factors are: business cycles, interest rate fluctuations, inflation rates, oil prices, etc. A multifactor model can accommodate these multiple sources of risk.

14

Discuss the advantages of the multifactor APT over the single factor APT and the CAPM

The single factor APT and the CAPM assume that there is only one systematic risk factor affecting stock returns. However, several factors may affect stock returns. Some of these factors are: business cycles, interest rate fluctuations, inflation rates, oil prices, etc. A multifactor model can accommodate these multiple sources of risk.

15

One shortcoming of the multifactor APT is that

the model provides no guidance concerning the factors or risk premiums on the factor portfolios. The CAPM implies that the risk premium on the market is determined by the market's variance and the average degree of risk aversion across investors.

16

17

Arbitrage arguments differ fundamentally from the risk-return dominance argument assumed when deriving the CAPM. More specifically:

 

Risk-return dominance

implies that when equilibrium price relationship is violated, many investors will make limited portfolio changes

Aggregation of these limited portfolio changes is required to create a large volume of buying and selling which in turn will act to restore equilibrium prices

18

Arbitrage arguments differ fundamentally from the risk-return dominance argument assumed when deriving the CAPM. More specifically:

 

Arbitrage

Arbitrage implies that a few investors quickly identify arbitrage opportunities and execute large trades to restore equilibrium prices.

 arbitrage arguments are perceived as stronger than those reached using risk-return dominance arguments, as arbitrage arguments rely on fewer investors to apply the pressure necessary to restore pricing equilibrium.

19

When portfolios have different betas:

An arbitrage opportunity exists in situations where portfolios have risk premiums that are not proportional to their betas

20

Arbitrage opportunities will not exist when

the expected return of all well-diversified portfolios lie on the SML

21

22

what is a well diversifed portfolio

include a large number of securities and the investment proportion in each is sufficiently small 

the proportion of a security in a well-diversifed portfolio is small enough so that a change in security's rate of return will have negligible effect on portfolio's rate of return

23

a well-diversified portfolio will have very small positions in all securities. Given this:

If only one security violates the expected return-beta relationship,

then the effect of this violation on a well-diversified portfolio will be too small to be of any importance, and meaningful arbitrage opportunities will not arise.

24

a well-diversified portfolio will have very small positions in all securities. Given this:

A portfolio including many securities that violate the expected return- beta relationship

would no longer satisfy the relationship itself, meaning arbitrage opportunities would arise.

25

a well-diversified portfolio will have very small positions in all securities. Given this:

no-arbitrage condition in a single-factor security market

implies that the expected return-beta relationship must be maintained for all well-diversified portfolios and the vast majority of individual securities.

26

The multifactor SML can be extended to

individual assets in much the same way as the one-factor APT can be. Moreover, well- diversified portfolios cannot satisfy this expected return-beta relationship unless the vast majority of individual asset also satisfy it.

27

an arbitrage opportunity arises when

two or more security prices allow investors to construct a zero-net investment portfolio that will yield a sure profit

presence of arbitrage opportunities will generate a large voluem of trades that puts pressure on security prices and will continue until there are no arbitrage opportunities

28

no arbitage condition

when securities are priced so that there are no risk free arbitage opportunities, they satisfy the no-arbitage condition. 

29

in a single factor security market, all well-diversifed portfolios will have to

satisfiy the expected return-beta relationship of the CAPM to stisfy the no-arbitage condition. 

If all well-diversified portfolios satisfy the expecte return-beta relationship, then individual assets also must satsfiy this relationship

30

Ross's APT relies on 3 key propositions

1. security returns can be determined by a factor model

2. there are sufficient securities to diversify away idiosyncratic risk

3. well-functioning security markets do not allow for the persistence of arbitage opportunities