Chapter 13- Testing CAPM/Anomalies

Question 1

What does CAPM tell us?

Answer 1

Higher beta leads to higher expected return

Question 2

What two important hypothesis must hold for CAPM to hold?

Answer 2

1. Intercept of SML = 0
2. Slope of SML = market risk premium > 0

Question 3

How do empirical estimates of SML relate to CAPM?

Answer 3

• empirically slope is much flatter and intercept is too high

Question 4

What reasons are there for low-risk investing?

Answer 4

• many investors have leverage constraints
• push up prices of risky stocks which lowers returns
• lowers prices of safe stocks increasing returns

Question 5

What anomalies occur that CAPM cannot explain?

Answer 5

1 firms with low P/E earn abnormal returns (Value Effect)
2. Small firms tend to have rates of return higher than predicted by CAPM (Size Effect)
3. Much of the abnormal returns to small firms occurs during the first two weeks of January (January Effect)
4. Average return to the S+P was reliably negative over weekend in the period 1953-1977 (Weekend Effect)
5. Recent past winners outperform recent past losers (Momentum Effect)

Question 6

What are anomalies evidence of?

Answer 6

Violation of Efficient Market hypothesis

Question 7

What is EMH?

Answer 7

Asset prices fully reflect information about the assets future cash flows and risks

Question 8

What are the three forms of market efficiency?

Answer 8

1. Weak
2. Semi-strong
3. Strong

Question 9

Define the weak form of market efficiency

Answer 9

• stock prices already reflect all information contained int he history of past prices

Question 10

Define the semi-string form of market efficiency

Answer 10

• stock prices already reflect all publicly available information

Question 11

Define the string form of market efficiency

Answer 11

• stock prices reflect all relevant information, including insider information

Question 12

What can occur if markets are not efficient?

Answer 12

• prices may diverge from fundamentals
• expected returns may be different than those predicted by the model
• investment decisions are unlikely to be efficient

Question 13

What does evidence suggest about market efficient in reality?

Answer 13

• that markets are efficient in the weak form and most likely in the semi-storm form, but not the strong form

Question 14

What is the adaptive market hypothesis?

Answer 14

ADH marries EMH principles with the irrational behavioural finance principle
- humans make best guesses based on trial and error

Question 15

What factors does the FF 3-factor model use to describe asset returns?

Answer 15

1. Volatility of market returns (systematic risk)
2. Firm size
3. Book-to-market-value

Question 16

What additional factor does the Carhart 4 factor model include to represent asset returns?

Answer 16

• momentum of expected returns

Question 17

What factors does the FF 5 factor model use to explain asset returns?

Answer 17

1. Systematic risk
2. Firm size
3. Book-to-market-value
4. Profitability
5. Investment