lec 3

• What is the main focus of the study material outlined in the document?

  More tests of CAPM and multifactor models
• What are the key components discussed under multifactor models?

  • Introduction
  • Arbitrage Pricing Theory (APT)
  • Macroeconomic factors
  • The three-factor model
• What does CAPM imply regarding the regression model discussed?

  CAPM implies that g2 = 0.
• What did Fama and MacBeth find regarding g2 and g3 in their tests of CAPM?

  They found that g2 and g3 are insignificant.
• What does the empirical SML being too flat indicate?

  It indicates that the CAPM may not fully explain asset returns.
• What does the equation \( g = rMt - rft \) represent in the context of CAPM?

  It represents the excess return of the market over the risk-free rate.
• What does the addition of firm size to the regression by Banz (1981) reveal?

  Banz found a negative g2 when firm size was added.
• What did Fama and French (1992) find when they added firm size and the book-to-market ratio?

  They found both firm size and book-to-market ratio to be significant, but beta was not.
• How did Fama and French (1992) conduct their double sort on size and beta?

  They sorted stocks first by size and then by market beta.
• What was the outcome of Fama and French's analysis regarding higher-beta stocks?

  Higher-beta stocks did not have higher returns, contrary to CAPM.
• What were the findings of Fama and French (1992) regarding average returns for portfolios formed on size and beta?

  • Beta is not significant in the 1963-1990 sample.
  • Size and book-to-market are highly significant.
• What is the size effect found in various countries according to the study material?

  Small firms tend to outperform large firms.
• What is the book-to-market effect observed in different countries?

  Firms with a high book-to-market ratio earn higher returns than predicted by CAPM.
• What distinguishes high B/M firms from low B/M firms?

  • High B/M firms: "value" stocks, stable cash flows, tangible assets.
  • Low B/M firms: "growth" stocks, volatile cash flows, few physical assets.
• What challenge does the existence of other variables besides beta pose to CAPM?

  It suggests that other models relating risk and return may be needed.
• What are the main assumptions of Arbitrage Pricing Theory (APT)?

  • Returns can be described by factors.
  • Idiosyncratic risk is diversified.
  • No arbitrage opportunities exist.
• What is an arbitrage opportunity?

  An opportunity to make sure profits without a net investment.
• How does a zero-investment portfolio differ from an ordinary portfolio?

  A zero-investment portfolio has weights that sum to 0, while an ordinary portfolio sums to 1.
• What types of risk does APT distinguish between?

  Factor risk (systematic) and idiosyncratic risk (diversifiable).
• What does the APT assume about residuals?

  Residuals are uncorrelated across assets.
• How does APT differ from CAPM in terms of investor preferences?

  APT assumes investors might care about more than just mean and variance.
• What are the multiple types of systematic risk mentioned in the study material?

  • Macro factors: GNP growth, inflation.
  • Financial factors: market risk, small stock risk, value versus growth risk.
• How are factor betas estimated in multifactor pricing models?

  By running a time-series regression of asset returns on specified factors.
• What is the main focus of the CAPM compared to APT?

  CAPM is preference-based, while APT is arbitrage-based.
• What does the APT result suggest about the alpha for most assets?

  For most assets, \( \alpha \approx 0 \).
• What is the implication of having \( \epsilon_{it} = 0 \) in the APT example?

  It suggests that arbitrage opportunities may exist if \( \alpha > 0 \).
• What do investors care about in their portfolio?

  Mean and variance
• Why do investors dislike assets that increase variance?

  Because they prefer stability in their investments
• What do investors demand in return for investing in assets that increase variance?

  Higher expected return
• What does CAPM explain regarding market factors?

  It explains why market factors are relevant
• What is the basis of the Arbitrage Pricing Theory (APT)?

  It is arbitrage-based
• How are factors treated in APT?

  Factors are taken as given and motivated by data
• Does APT explain where the factors come from?

  No, APT does not explain where the factors come from
• What is the APT result for most assets regarding alpha?

  • For most assets, \( \alpha \approx 0 \)
  • This result is similar to CAPM but derived under different assumptions
• What is the formula for asset returns in the APT model?

  \( r_i - r_f = \alpha_i + \beta_i (r_m - r_f) + \epsilon_i \)
• What happens if \( \epsilon_i = 0 \) in the APT model?

  Arbitrage opportunities arise if \( \alpha_i > 0 \)
• How can arbitrage be achieved with a portfolio of a risk-free asset and the market portfolio?

  By considering the weight \( \beta_i \) of the asset
• What does no-arbitrage imply about \( \alpha_i \)?

  No-arbitrage implies \( \alpha_i = 0 \)
• What is the implication of \( \epsilon_i \neq 0 \) in APT?

  Exact arbitrage is not possible
• How do well-diversified investors view idiosyncratic risk?

  Idiosyncratic risk is irrelevant and not compensated