CAPM Questions

Edward Somerby, CFA, recently attended a seminar on asset pricing models. In the seminar the capital asset pricing model (CAPM) and arbitrage pricing theory (APT) were discussed. Somerby’s supervisor has asked him to share his knowledge and lead an in-house seminar for some newly hired analysts. The analysts were somewhat skeptical about the practical applications of these theories and raised the following issues in the discussion with Somerby. Which of the following is the least legitimate concern with the implementation of the CAPM in practice? A) The market portfolio is not attainable in practice. B) Positive skewness in returns of high-risk stocks is found to be present. C) The inability to lend and borrow at a risk-free rate of return. D) The large number of covariance calculations necessary to estimate betas. The CAPM requires the estimation of an appropriate benchmark for the market portfolio. Benchmark error can NOT lead to which of the following? A) Over-estimating a manager’s performance. B) Errors in calculating betas. C) Misrepresenting the slope of the security market line (SML). D) Book-to-market values that are better predictors of return than beta The analysts are concerned that the slope of the security market line (SML) may not be properly measured. Which of the following will least likely change the slope of the SML? A) Changes in risk premium. B) Different borrowing and lending rates C) Benchmark error D) Changes in inflation expectations. In comparing the APT and CAPM, the analysts felt the APT was a more practical model. Which of the following assumptions is NOT necessary for the APT model? A) Capital markets are competitive. B) Investors prefer more wealth to less. C) Investors have homogenous expectations. D) The process generating asset returns can be represented by a k-factor model

I’ll give it a try A D C d? just guessing on last one

My guesses: D - Spreadsheets and online price databases should make this irrevelent D - The benchmark error shouldn’t have any effect on other book-to-market values D - Choosing this because I feel the other three will change the slope, but inflation might just move the line up or down or have no real effect on the line (i haven’t done the macroeconomics yet, so this is a rough guess) C - Investors can customize their own preferences with APT Moto376, do you have the answers?

Answers are: C - A zero-beta portfolio can be substituted for the risk-free asset. Therefore, no assumptions regarding equal borrowing and lending rates is necessary. Furthermore, differences in borrowing and lending rates can be assumed to be appropriate and used in the construction of the capital market line (CML). The result is a CML that is bent around the market portfolio. The portion of the CML connecting the risk-free asset and market portfolio will have a steeper slope than the portion of the CML extending beyond the market portfolio. d - The existence of positive skewness in the returns of high-risk stocks appears to be related to their lower than expected returns. Studies have shown book-to-market values have more explanatory power than beta in explaining returns for this group of securities. This problem is unrelated to the benchmark error problem. The benchmark error problem stems from the fact that a proxy (index) is necessary for the market portfolio, but the wrong index is selected. d - Changes in inflation expectations will result in parallel shifts upward or downward in the SML, but the slope of the line will not be changed. c - The (CAPM) assumes that all investors have homogenous expectations. However, this is not a necessary assumption of the APT. The APT is less restrictive than the CAPM. In fact, the CAPM is a subset of the APT, where in the CAPM it is assumed that only the relationship to the market portfolio is useful in explaining returns.

Is the last question even relevant for this year’s L1? I search through all the LOSs and there were nothing on APT, also I checked the index and there were nothing detail or useful on APT…

I was wondering if this was relevant as well. It did come from level 1 Schweser Qbank though.

you know schweser, I don’t really have complete confidence in them, I only use them to help me drill the concepts in, they have LOTS of mistakes and questions that you can tell are from the past and probably not relevant anymore… also, the return skewness discussion on CAPM and beta was marked as optional in the CFAI text too…

I did Port mgmt from CFAI books, APT, benchmark errors and impact of skewness are in the “optional segment”. I can’t be bothered with that.

Thank you so much Liaaba… i thought i have missed the APT part as well… scaryyyyyyyyyyyyyyyyyyyyyyyy!!!