Professor Burton Fall 2016 October 25 2016 CAPM Problems Unsatisfying statistical theory Broad criticism Rolls critique Lack of empirical validation Fama French Problems with diversification notion ID: 587026
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Slide1
Economics 434: The Theory of Financial Markets
Professor BurtonFall 2016
October 25, 2016Slide2
CAPM ProblemsUnsatisfying “statistical” theoryBroad criticismRoll’s critiqueLack of empirical validation (Fama-French)Problems with “diversification” notion
Data problems
October 25, 2016Slide3
Which Way to Go from CAPMArbitrage Pricing Theory, 1977, Steve RossFinite State Version of CAPMOctober 25, 2016Slide4
Arbitrage Pricing TheoryDeveloped by Steve Ross, 1976Uses “No-Arbitrage” AssumptionDesigned to provide “economic” variables to the determination of asset pricingAvoids the “single risky asset portfolio” problem
October 25, 2016Slide5
The Starting Point of APTOctober 25, 2016
+
+ … +
R
i
is the return in a single period for stock i
Is the expected return of stock i
is the “unanticipated” change in factor iSlide6
After a bit of linear algebra and taking a limit of arbitrage portfolios that increase in sizeOctober 25, 2016
+ …
What is
?
= E
The expected excess return attributable to a
beta of one exposure to factor iSlide7
So, What are the Economic FactorsAccording to Richard Roll & Steve RossInflationIndustrial productionRisk premiums (credit spreads)Slope of the term structure of interest rates
October 25, 2016Slide8
October 25, 2016