{[ promptMessage ]}

Bookmark it

{[ promptMessage ]}

09- Single Factor Model and CAPM

09- Single Factor Model and CAPM - Single Factor Models and...

Info icon This preview shows pages 1–13. Sign up to view the full content.

View Full Document Right Arrow Icon
1 Single Factor Models and the CAPM Marriott School of Management Bus M 410 Winter 2011 Rob Schonlau Last updated Feb 14, 2010
Image of page 1

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Lecture 9 Outline l Introduce single factor asset pricing models. Use intuition developed from regression lecture (slide set 8) to understand betas. l Example estimation of the single index model. l Introduce the CAPM l Relate the CAPM and single factor (index) model. Review miscellaneous points regarding the application of the CAPM. 2
Image of page 2
What is a “factor model”? l “Factor models are statistical models designed to estimate [systematic and firm-specific] risk for a particular security or portfolio.” -- BKM page 171 l I think of factor models as regression equations where asset returns (the dependent variable) are being modeled as a function of various explanatory variables motivated by financial theory. These regression equations allow the return being modeled to be viewed as function of systematic and firm- specific components. 3
Image of page 3

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Intuition for single factor model l Suppose we set out to model asset returns. For simplicity let’s concentrate on stocks for now. The dependent variable in the model will be stock i’s returns. l We know that individual stock prices, and hence returns, are affected by various firm-level and market-wide events (e.g., business cycles, interest rates, war, inflation, new technology, hiring/firing/death of key employees, etc.). For simplicity we will conceptually group industry and region-level events under the “market-wide” category and focus on a single market- wide factor. 4
Image of page 4
Single factor model intuition continued… 5
Image of page 5

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Single factor model intuition continued… 6
Image of page 6
Single factor model  single index model 7
Image of page 7

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Single index model (this is the form of the single factor model that can be estimated using real-world data) 8
Image of page 8
Intuition from a factor (index) model. Ri = α i + β i Rm + ei Once we have a model we can ask (model-based) questions like: What is the expected return ? E[Ri]= α i + β i E[Rm] What is the variance? Let var2(Rm)= σ2m. Var[Ri] = Var[ α i + β i Rm + ei] = Var[ β i Rm]+Var[ei] = σ2( β iRm) + σ2(ei) = β i2 σ2m + σ2(ei) =systematic risk + firm-specific risk 9
Image of page 9

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Lecture 9 Outline l Introduce single factor asset pricing models. Use intuition developed from regression lecture (slide set 8) to understand betas. l Example estimation of the single index model. l Introduce the CAPM l Relate the CAPM and single factor (index) model. Review miscellaneous points regarding the application of the CAPM. 10
Image of page 10
11 How to estimate the parameters in an index model?
Image of page 11

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
12 Steps for setting up the estimation l Decide on an estimation period Services use periods ranging from 2 to 5 years for the regression Longer estimation period provides more data, but firms change. Shorter periods can be affected more easily by significant firm-specific event that occurred during the period (Example: ITT for 1995-1997) l Decide on a return interval - daily, weekly, monthly Shorter intervals yield more observations, but suffer from more noise.
Image of page 12
Image of page 13
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern