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Brailsford3eSM_Ch09 - Chapter 9 Alternative risky asset...

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Copyright © 2006 Nelson Australia Pty Limited Chapter 9 Alternative risky asset pricing models Learning objectives After the completion of this chapter, you should be able to: describe the asset pricing models that are alternatives to the CAPM understand the specific asset pricing models, in particular the arbitrage pricing theory (APT), the consumption CAPM (CCAPM), Fama–French three factor model and international asset pricing models understand the importance of the assumptions underlying these models appreciate the empirical support for these models compare the CAPM to alternative models and understand their relative strengths and weaknesses apply these models in pricing risky assets Key points 1 Asset pricing models share the common objective of modelling the relationship between expected returns and risk. 2 The models differ in terms of the underlying assumptions of the model. These assumptions result in differing measurement of systematic risk. 3 Some examples include single factor models like the CCAPM and the International APM, which can be contrasted with multiple factor models like the Ross APT and the Fama and French model. Chapter outline 9.1 Introduction 1 A number of asset pricing models are considered in this chapter. For comparative purposes, these are compared with the CAPM as a base case. 2 The CAPM makes a useful base case as it consists of a single domestic risk factor. This makes the model comparatively simple to estimate and put into practice. 9.2 Consumption CAPM (CCAPM) 1 The CCAPM was developed by Rubinstein (1978). 2 Under the CCAPM, expected returns are determined by the asset’s exposure to the growth rate of aggregate consumption. 3 Early tests of the CCAPM found moderate evidence for this model, however availability of high frequency data is a problem associated with applying the model in practice.
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2 Investments: Concepts and Applications Solutions Manual Copyright © 2006 Nelson Australia Pty Limited 9.3 The arbitrage pricing theory 1 The APT was developed to overcome the CAPM shortcoming associated with the identification of the market portfolio. 2 Under the APT, assets will price two assets identically if they have the same systematic risk. Hence, the model relies on a no arbitrage assumption and does not require a market portfolio, normality in asset returns nor investors to have quadratic utility. 3 The major criticism is the lack of theory on the number and identity of the factors. 9.4 Fama and French three-factor model 1 The Fama and French model developed from the beta is dead argument. 2 Under the model, asset returns will depend upon their size and book-to-market ratio in addition to beta. 9.5 International asset pricing models 1 The International APM recognises that some national risk is diversifiable in an international context.
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