I-CAPM was first introduced in 1973 by Merton. It is an extension of CAPM which recognizes not only the familiar time-independent CAPM beta relationship, but also additional factors that change over time (hence “intertemporal”).
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.
Repurchase agreements are contracts involving the simultaneous sale and future repurchase of an asset, most often Treasury securities. Typically, the seller buys back the asset at the same price at which it sold. On the buy-back date, the original seller pays the original buyer interest on the implicit loan created by the transaction. Interest due on a repo at maturity is at the rate for the stated maturity of the repo.
A reverse repo, or simple a reverse, is a contract in which a repo is structured so that a broker/dealer, a bank, or another party that normally uses the repo market to fund (finance) itself is cast in the role of securities purchaser and money lender Broker/dealers often cover shorts by reversing in securities.
A sell/buyback is essentially the same as a repo, except for the treatment of coupon interest. Coupon payments are not forwarded to the investor by the counterparty. Instead, the counterparty pays the investor repo interest on the coupon payment. When the sell/buyback terminates, the investor will receive its accrued coupon interest from the counterparty. A sell/buy back transaction also differs from a repo transaction in that the sales price for securities delivered differs from the purchase price paid when the securities are returned. The difference in the price of the sale and purchase transactions accounts for the amount of accrued coupon interest earned and the financing cost charged during the term of the loan.