Chapter 9: Multifactor Models of Risk and Return. (QUESTIONS) 1. Both the capital asset pricing model and the arbitrage pricing theory rely on the proposition that a no-risk, no-wealth investment should earn, on average, no return. Explain why this should be the case, being sure to describe briefly the similarities and differences between CAPM and APT. Also, using either of these theories, explain how superior investment performance can be establish.

Answer:
Both the Capital Asset Pricing Model and the Arbitrage Pricing Model rest on the assumption that investors are reward with non-zero return for undertaking two activities:
(1) committing capital (non-zero investment); and (2) taking risk. If an investor could earn a positive return …show more content…

4. Some studies related to the efficient market hypothesis generated results that implied additional factors beyond beta should be considered to estimate expected returns. What are these other variables and why should they be considered?

Answer:

Studies of the efficient markets hypothesis suggest that additional factors affecting estimates of expected returns include firm size, the price-earnings ratio, and financial leverage. These variables have been shown to have predictive ability with respect to security returns.

5. Suppose you are considering the purchase of shares in the XYZ mutual fund. As part of your investment analysis, you regress XYZ’s monthly returns for the past five years against the three factors specified in the Fama and French models. The procedure generates the following coefficient values means. What types of stocks is XYZ likely to be holding?

Answer:

A market factor of 1.2 means the mutual fund is 1.2 times as sensitive as the market portfolio, all other factors held equal. The SMB (“small minus big”) factor is the return of a portfolio of small capitalization stocks minus the return to a portfolio of large capitalization stocks. A value of –0.3 indicates the fund tends to react negatively to small cap factors; thus the fund is primarily invested in large cap stocks. The HML (“high minus low”) factor is the return to a portfolio of stocks