We have devoted a lot of blog space in the past examining the pros and cons of the Capital Asset Pricing Model (CAPM). The model predicts the amount of excess return (return above the risk-free rate) of an arbitrary portfolio that can be ascribed to a relationship (called beta[1]) to the excess returns on the underlying market portfolio.
Click here for reuse options! Having previously discussed them, let’s compare them. How does the Arbitrage Pricing Theory (APT) stack up against the Capital Asset Pricing Model (CAPM)?
Click here for reuse options! Arbitrage Pricing Theory (APT) is a multi-factor model in which a series of input variables, such as macroeconomic indicators and market indices, are each assigned their own betas to determine the expected return of a target asset.
Click here for reuse options! Arbitrage Pricing Theory (APT) is a multi-factor model conceived by Stephen Ross in 1976. It is a linear equation in which a series of input variables, such as economic indicators and market indices, are each assigned their own betas to determine the expected return of a target asset. These factor-specific betas (b) fine-tune the sensitivity of the target asset’s rate of return to the particular factor.
Click here for reuse options! In the first three installments, we looked closely at the assumptions that underlie the Capital Asset Pricing Model (CAPM), as part of our overall project of investigating the role of alpha in hedge fund performance. Today we will review the basic CAPM equations.
Click here for reuse options! In Parts One and Two of our examination of the Capital Asset Pricing Model (CAPM), we evaluated two major assumptions:
1) Market returns are properly modeled by a normal distribution
2) Beta (systematic risk) is the sole source of priced risk for an asset or portfolio of asset
As you recall, we found several weaknesses in both assumptions as they may apply to hedge funds. This time, we’ll examine the remaining assumptions underlying CAPM, and see if each is reasonable when applied to hedge fund trading.
CAPM assumes: Continue reading “Capital Asset Pricing Model, Part Three – Other Assumptions” »
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