Unformatted text preview: .e. have zero sensitivity to
each factor) is essentially risk-free and will therefore be priced such that it offers the risk-free rate
2. A diversified portfolio designed to be exposed to e.g. factor 1, will offer a risk premium that
varies in proportion to the portfolio's sensitivity to factor 1.
5.7.2 Consumption beta If investors are concerned about an investment's impact on future consumption rather than wealth, a
security's risk is related to its sensitivity to changes in the investor's consumption rather than wealth. In
this case the expected return is a function of the stock's consumption beta rather than its market beta.
Thus, under the consumption CAPM the most important risks to investors are those the might cutback
5.7.3 Three-Factor Model The three factor model is a variation of the arbitrage pricing theory that explicitly states that the risk
premium on securities depends on three common risk factors: a market factor, a size factor, and a book-tomarket factor:
(35) Expected risk premium bmarket (rmarket fa cot r ) bsize (rsize factor ) bbook to market (rbook to market ) Where the three factors are measured in the following way:
- Market factor is the return on market portfolio minus the risk-free rate
Size factor is the return on small-firm stocks minus the return on large-firm stocks (small minus
Book-to-market factor is measured by the return on high book-to-market value stocks minus the
return on low b...
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This note was uploaded on 10/26/2012 for the course 19 19 taught by Professor - during the Spring '12 term at Sunway University College.
- Spring '12