Arbitrage pricing theory Flashcards
(34 cards)
What are the two sources of security returns?
The two main sources of security returns are a common macroeconomic factor and firm specific events
What are two main macro factors affecting returns?
The two main macro factors affecting security returns are interest rates and GDP
In Ri = E(Ri) + BF + ei, what are the coefficients?
In the above equation, E(Ri) is the expected return of the investment, B is the sensitivity of the security to a factor, and F is the value of a shock in that factor. Ei is a firm-specific event
Both F and e have … … value
Both F and E have zero expected value
The APT predicts a security market line linking … … to …
The APT predicts a security market line linking expected returns to risk
What are the three propositions of the APT SML?
- Securities described with a factor model
- There are enough securities to diversify away idiosyncratic (firm-specific) risk
- Arbitrage will disappear quickly
What is an arbitrage opportunity?
An arbitrage opportunity is when a zero-investment portfolio has a sure profit
Why do investors take large positions in arbitrage opportunities?
Investors take large positions in these arbitrage opportunities because they are risk free and investors want to therefore maximise their returns before the opportunity closes.
Investors want a large position in the risk free arbitrage portfolio regardless of … … or …
Investors want a large position in the risk free arbitrage portfolio regardless of risk aversion or wealth
What will happen to profitable arbitrage opportunities in efficient markets?`
Profitable arbitrage opportunities in efficient markets will close when the lower priced asset is bid up in price, and the higher priced asset is shorted down. (They will disappear quickly)
What is the critical assumption of CAPM?
The critical assumption of the CAPM model is that a large number of investors are mean-variance optimisers
Explain what the terms mean for a single factor portfolio above
Above, for a single factor portfolio, Bp is the weighted factor sensitivity, E(rp) is the weighted expected return, wi = 1 means the weights add to 100% (1)
In a well-diversified portfolio, ep Approaches … as the number of … in the … increases and their associate weights … `
In a well-diversified portfolio, ep approaches zero as the number of stocks in the portfolio increases and their associate weights decrease.
We can conclude any realized value of ep will be virtually …
We can conclude any realized value of ep will be virtually zero
When two assets have different returns but the same … there is an … opportunity
When two assets have different returns but the same beta there is an arbitrage opportunity
Why will arbitrage opportunity mean alpha/risk premium is equal to zero?
Arbitrage opportunity means alpha/risk premium is equal to zero because we can expect arbitrage opportunities to be cancelled out by an efficient market, meaning alpha, which represents the non-market return, is equal to zero.
APT equilibrium means no … opportunities
APT equilibrium means no arbitrage opportunities
What happens to APT equilibrium upon arbitrage?
Upon arbitrage, the APT equilibrium is restored.
APT assumes a … portfolio
APT assumes a diversified portfolio, where residual risk is still a factor
CAPM model is based on a … portfolio
The CAPM model is based on an unobservable market portfolio
CAPM rests on …-… efficiency
CAPM rests on mean-variance efficiency, where the actions of many investors restore CAPM.
CAPM describes … for all …
CAPM describes equilibrium for all assets
To select factors for the multifactor APT, we choose those that are important to…
To select factors for the multifactor APT, we choose factors that are important to the performance of the general economy.
Factor portfolios track… but are uncorrelated with…
Factor portfolios track a particular economic risk source, but are uncorrelated with other sources of risk.
