Carrie Marcel, CFA, has long used the Capital Asset Pricing Model (CAPM) as an investment tool. Marcel has recently begun to appreciate the advantages of arbitrage pricing theory (APT). She used reliable techniques and data to create the following two-factor APT equation:
E(RP) = 6.0% + 12.0%βp,ΔGDP – 3.0%βp,ΔINF
Where ΔGDP is the change in GDP and ΔINF is the change in inflation. She then determines the sensitivities to the factors of three diversified portfolios that are available for investment as well as a benchmark index:Portfolio | Sensitivity to ΔGDP | Sensitivity to ΔINF | Q | 2.00 | 0.75 | R | 1.25 | 0.50 | S | 1.50 | 0.25 | Benchmark Index | 1.80 | 1.00 |
Marcel is investigating several strategies. She decides to determine how to create a portfolio from Q, R, and S that only has an exposure to ΔGDP. She also wishes to create a portfolio out of Q, R, and S that can replicate the benchmark. Marcel also believes that a hedge fund, which is composed of long and short positions, could be created with a portfolio that is equally weighted in Q, R, S and the benchmark index. The hedge fund would produce a return in excess of the risk-free return but would not have any risk. Which of the following statements least likely describes characteristics of the APT and the CAPM? A)
| The APT is more flexible than the CAPM because it allows for multiple factors. |
| B)
| Both models assume firm-specific risk can be diversified away. |
| C)
| Both models require the ability to invest in the market portfolio. |
|
The CAPM can be thought of as a subset of the APT, multifactor model. Therefore, fewer assumptions are needed for the APT model than the CAPM. Although it could be included as a factor, the APT does not require an investment in the market portfolio. APT can be thought of as a k factor model, while the CAPM is based on the risk-free asset and the market portfolio.
What is the APT expected return on a factor portfolio exposed only to ΔGDP?
A factor portfolio is a portfolio with a factor sensitivity of one to a particular factor and zero to all other factors. The expected return on a “factor 1” portfolio is E(RR) = 6.0% + 12.0% (1.00) − 3.0%(0.00) = 18.0%. |