IPT 1 Chapter 10

Question 1

What are the two source of uncertainty of asset return?

Answer 1

1. A macroeconomic factor
2. Firm specific events

Question 2

What are the three key assumptions of arbitrage pricing theory?

Answer 2

1. Asset returns can be described by a factor model
2. There are sufficient assets to diversify away the idiosyncratic risk
3. Well-functioning security markets do not allow or the persistence of arbitrage opportunities

Question 3

How is the Fama-French Three-Factor model made up of?

Answer 3

Uses firm characteristics that seem to proxy for exposure to systematic risk
where SMB is the return of a portfolio of small stocks in excess of the return on a portfolio of large stock
Where HML the return of a portfolio of stocks with a high book-to-market ratio in excess of the return on a portfolio of stocks with a low book-to-market ratio