Capital Asset Pricing Model
Chapter 9: Multifactor Models of Risk and Return. (QUESTIONS) 1. Both the capital asset pricing model and the arbitrage pricing theory rely on the proposition that a no-risk, no-wealth investment should earn, on average, no return. Explain why this should be the case, being sure to describe briefly the similarities and differences between CAPM and APT. Also, using either of these theories, explain how superior investment performance can be establish.
Answer:
Both the Capital Asset Pricing Model and the Arbitrage Pricing Model rest on the assumption that investors are reward with non-zero return for undertaking two activities:
(1) committing capital (non-zero investment); and (2) taking risk. If an investor could earn a positive return for no investment and no risk, then it should be possible for all investors to do the same. This would eliminate the source of the “something for nothing” return.
In either model, superior performance relative to a benchmark would be found by positive excess returns as measured by a statistically significant positive constant term, or alpha. This would be the return not explained by the variables in the model.
2. You are the lead manager of a large mutual fund. You have become aware that several equity analysts who have recently joined your management team are interested in understanding the differences between the capital asset pricing model (CAPM) and arbitrage models can helps them perform better security analysis. a. Explain what the CAPM and APT attempt to model. What are the main differences between these two asset pricing models? b. Under what circumstances would the APT be preferred over the CAPM as a tool for selecting stocks for the fund portfolio?
Answer:
a. The Capital Asset pricing Model (CAPM) is an equilibrium asset pricing theory showing that equilibrium rates of expected return on all risky assets are a function of their covariance with the market portfolio. The CAPM is a single-index
Answer:
Both the Capital Asset Pricing Model and the Arbitrage Pricing Model rest on the assumption that investors are reward with non-zero return for undertaking two activities:
(1) committing capital (non-zero investment); and (2) taking risk. If an investor could earn a positive return for no investment and no risk, then it should be possible for all investors to do the same. This would eliminate the source of the “something for nothing” return.
In either model, superior performance relative to a benchmark would be found by positive excess returns as measured by a statistically significant positive constant term, or alpha. This would be the return not explained by the variables in the model.
2. You are the lead manager of a large mutual fund. You have become aware that several equity analysts who have recently joined your management team are interested in understanding the differences between the capital asset pricing model (CAPM) and arbitrage models can helps them perform better security analysis. a. Explain what the CAPM and APT attempt to model. What are the main differences between these two asset pricing models? b. Under what circumstances would the APT be preferred over the CAPM as a tool for selecting stocks for the fund portfolio?
Answer:
a. The Capital Asset pricing Model (CAPM) is an equilibrium asset pricing theory showing that equilibrium rates of expected return on all risky assets are a function of their covariance with the market portfolio. The CAPM is a single-index