week 6 Flashcards
(34 cards)
What does the CAPM say about expected returns?
Expected returns increase linearly with beta; only systematic risk is rewarded.
CAPM formula for expected returns?
E(r_i) = r_f + β_i (E(r_m) - r_f)
What is the Security Market Line (SML)?
A graph of expected excess returns vs beta. Under CAPM, all assets lie on the SML.
What is the slope of the SML?
Average excess market return (E(r_m) - r_f)
What is the intercept of the SML under CAPM?
Zero (0)
Regression form of realised CAPM?
r_i - r_f = α_i + β_i (r_m - r_f) + ε_i
What should alpha be if CAPM holds?
Alpha should be zero.
Why don’t we use the true market portfolio in CAPM tests?
Because it includes all assets, many of which are unobservable (e.g., human capital).
What proxy is used for the market portfolio?
A broad stock market index like the S&P 500.
Why is estimating beta from individual stocks problematic?
Firm-specific noise causes measurement error in beta.
How does using portfolios improve CAPM tests?
Diversifies away firm-specific risk and improves beta estimation.
What did Lintner (1965) find about the SML?
It was too flat: intercept was 12.7%, slope was 4.2%, deviating from CAPM predictions.
Implication of flat SML in Lintner’s study?
Low-beta stocks earned too much, high-beta stocks earned too little.
What causes bias in SML slope and intercept?
Measurement error in beta (independent variable) biases slope downward and intercept upward.
How can forming portfolios address measurement error?
Combines stocks to average out firm-specific noise and better estimate beta.
What is the Fama-MacBeth regression method?
Two-stage regression: estimate betas in time series, then regress average returns on betas.
In Fama-MacBeth, what should γ₀ equal?
The risk-free rate (r_f)
In Fama-MacBeth, what should γ₁ equal?
The average excess market return (E(r_m) - r_f)
What does a significant γ₃ imply in Fama-MacBeth?
Non-systematic risk might be priced, contradicting CAPM.
What did Fama-MacBeth find about γ₂ and γ₃?
Both were generally insignificant, supporting CAPM assumptions.
What are the three Fama-French factors?
Market excess return, SMB (size), HML (value)
What is SMB?
Small Minus Big: return difference between small and large firms.
What is HML?
High Minus Low: return difference between value and growth firms.
Fama-French 3-factor regression formula?
r_i - r_f = α_i + b_i (r_m - r_f) + s_i SMB + h_i HML + ε_i
