Hi, I have a couple questions from the Portfolio Management section. Can anyone please answer these two questions: a) Why do we need extended CAPM? Extended CAPM is used to apply domestic CAPM in the international context. But when we also have ICAPM for international valuation purposes why do we need extended CAPM at the first place? b) Schweser notes discuss on page 181 - Overfitting problem and the time instability problem related to the instability in the minimum variance frontier. I don’t understand these concepts really well. Can anyone please explain these concepts in simple language? thanks!
a) I’m pretty sure extended CAPM is ICAPM b) I wouldn’t worry much about this- it’s just saying how the frontier changes based on our imputs and is imperfect for the reasons they list there
I believe expanded CAPM is related to private company valuation and its CAPM + small co premium and company-specific risk premium. The ICAPM includes foreign currency risk premiums.
twinkle7 Wrote: ------------------------------------------------------- > b) Schweser notes discuss on page 181 - > Overfitting problem and the time instability > problem related to the instability in the minimum > variance frontier. I don’t understand these > concepts really well. Can anyone please explain > these concepts in simple language? Very simple example with two very highly correlated assets (for example, you can only go long and you can buy Euro/USD from two different banks, same volatility, correlation of 1) A and B with the same volatility 10%, correlation of 1 and same expected returns (around 5%). Let’s say you reoptimize based on historical return of the last 1 year. It might happen that return on A is just slightly higher than return of B (5.0001% vs 4.9998%). Mean-variance optimization would tell you to invest 100% in A. One day later as you look at rolling one year return, you might see that return of B is just slightly higher (5.0002% vs 5.0%). Mean-variance optimization would tell you to invest everything in B. You should expect to see high sensitivity when there are highly correlated assets (if assets are uncorrelated, sensitivity is low). Does that help?
Thanks for getting back. On page 488 R# 68, they talk about how to extend domestic CAPM to international context - Domestic CAPM extended to international context. I undertstand that Expanded CAPM (used for Private company valuation) is a different concept than extended Domestic CAPM. Also, I am sure that domestic CAPM extended to international context is different than ICPAM because the underlying assumptions are different for both. Please reflect on this issue. Why do we need to extend domestic CAPM to international context when we have ICAPM?