# CAPM limitation 11 How much data should we collect?

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Investment theory, class #3 Page 1 of 26 ® All rights reserved to Tal Mofkadi A course in investment theory Class #3 – Factors model Arbitrage Pricing Theory By: Tal Mofkadi
Investment theory, class #3 Page 2 of 26 ® All rights reserved to Tal Mofkadi 1 CAPM LIMITATION .................................................... 3 1.1 H OW MUCH DATA SHOULD WE COLLECT ? ............................................... 3 1.2 P OSSIBLE ERRORS IN CORRELATION COEFFICIENTS ............................... 4 2 THE INDEX (FACTOR) MODEL ................................ 5 2.1 S INGLE INDEX MODEL ................................................................................ 5 3 THE CAPM IN PRACTICE (SINGLE INDEX MODEL) ................................................................................. 9 3.1 T HE RISK FREE RATE OF RETURN .............................................................. 9 3.2 C ALCULATE Β E ........................................................................................... 9 3.3 T HE MARKET RISK PREMIUM .................................................................. 10 3.3.1 Implied risk premium history ............................................................. 11 3.3.2 Implied vs. realized risk premium ...................................................... 12 3.4 S MALL SIZE PREMIUM .............................................................................. 12 3.5 M ULTIFACTOR MODELS ........................................................................... 13 3.5.2 Theoretical Foundations of Multifactor Models ............................... 14 3.5.3 Where do we look for factors (ICAPM)? ........................................... 15 4 ARBITRAGE PRICING THEORY ............................ 16 4.1 A RBITRAGE DEFINITION .......................................................................... 16 4.2 T HE APT ................................................................................................... 16 4.2.1 Example 1: ......................................................................................... 17 4.2.2 Example 2 .......................................................................................... 18 4.2.3 Conclusion: ........................................................................................ 18 4.2.4 The APT and the CAPM .................................................................... 20 4.3 M ULTIFACTOR APT ................................................................................. 22 4.3.2 Conclusion ......................................................................................... 23 5 ALTERNATIVE PRICING MODEL ......................... 24 5.1 C ONSUMPTION CAPM - CCAPM ........................................................... 24 5.1.1 Example ............................................................................................. 25 5.1.2 Results ................................................................................................ 26 6 FURTHER TOPICS ..................................................... 26 6.1 T HE EQUITY PREMIUM PUZZLE ............................................................... 26
Investment theory, class #3 Page 3 of 26 1 CAPM limitation 1.1 How much data should we collect?