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Chapter 10 Slides FIN 4352
Chapter 10 Slides FIN 4352
Chapter 10
macro-economic factor
specific events
Interest
Rates
FIN 435 (Instructor- Saif Rahman)
Multifactor Models
Use
Examples
Arbitrage - arises if an investor can construct a zero investment portfolio with a sure profit. Risk-less profit with zero initial outlay or investment. Since no investment is required, an investor can create large positions to secure large levels of profit. In efficient markets, profitable arbitrage opportunities will quickly disappear. Example the same product is being transacted in two shops. The price in Shop A is Tk. 20 whereas in Shop B, the price is Tk. 22. Assume buying and selling prices are same. What will happen? How can you make risk-less profit with no initial outlay or investment? How will this arbitrage opportunity disappear in an efficient market? FIN 435 (Instructor- Saif Rahman) The Law of One Price
The expected returns of each security will be a function of its factor s The model is derived by showing that for well diversified portfolios, if the portfolios expected return (price) is not equal to the expected return predicted by the portfolios s, then there will be an arbitrage opportunity
Note that fewer assumptions are necessary to derive the APT (than are necessary to derive the CAPM)
FIN 435 (Instructor- Saif Rahman)
Arbitrage Example
Current Stock Price$ A 10 B 10 C 10 D 10 Expected Return% 25.0 20 32.5 22.5 Standard Corr. Dev.% 29.58 AB -0.15 33.91 BC -0.87 48.15 AC -0.29 8.58
Arbitrage Portfolio
Mean Portfolio A,B,C D
25.83
S.D.
6.40
22.25
8.58
F
Portfoli o
F Individual Security
FIN 435 (Instructor- Saif Rahman)
Disequilibrium Example
E(r)%
10 D 7 6 Risk Free 4 C A
.5
1.0
Beta for F
Disequilibrium Example
Short Portfolio C Use funds to construct an equivalent risk higher return Portfolio D.
Arbitrage profit of 1%
[E(rM) - rf]
Risk Free
1.0
The CAPM is a special case of APT that would result if the single common factor affecting all security returns was the return on the market portfolio. APT is more general, or robust, than the CAPM. It is based on less restrictive assumptions. APT does not identify either the number or the definition of the factors affecting returns. These have to be empirically determined by fitting a factor model to returns. The CAPM is a well-specified model, where the parameters of the model are spelled out up front. However, it relies on the Market Portfolio, which is in principle non measureable. APT is more general in that it gets to an expected return and beta relationship without the assumption of the market portfolio. APT can be extended to multifactor models.
order to implement the APT we need to know what the factors are! Here the theory gives no guidance. There is some evidence that the following macroeconomic variables may be risk factors:
1)Changes in monthly GDP 2)Changes in the default risk premium 3)The slope of the yield curve 4)Unexpected changes in the price level
5)Changes in expected inflation Note that the difficulty of measuring expected inflation makes the estimation of 4 & 5 difficult
FIN 435 (Instructor- Saif Rahman)
The factors chosen are variables that on past evidence seem to predict average returns well and may capture the risk premiums
Where: SMB = Small Minus Big, i.e., the return of a portfolio of small stocks in excess of the return on a portfolio of large stocks HML = High Minus Low, i.e., the return of a 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
A multi-index CAPM will inherit its risk factors from sources of risk that a broad group of investors
deem important enough to hedge
The APT is largely silent on where to look for priced sources of risk