Multi Factor Models, Efficient Market Hypothesis and Behavioural Finance

Question 1

What is a multi-Factor Model

Answer 1

1. allows for different sensitivities to factors to impact returns

Question 2

Name 2 Multi-Factor Models

Answer 2

1. Fama and French Model
2. Arbitrage pricing Theory

Question 3

Explain Fama and French Model and what they found

Answer 3

1. Expands CAPM to include company size and value.
2. They found small cap and value stocks out perform large and growth stocks

Question 4

Explain Arbitrage Pricing Theory

Answer 4

1. a security’s returns can be predicted using the relationship between the security and a number of common risk factors.
2. This can then be used to price the security.
3. If the price diverges, arbitrage activities should bring it back into line.

Question 5

Explain the Efficient Market Hypothesis

Answer 5

1. In an open and efficient market, security prices fully reflect all available information and rapidly adjust to any new information.

Question 6

Explain the 3 forms of EMH

Answer 6

1. Weak-form efficiency:
   
   • current security prices fully reflect all past information, and future prices cannot be predicted
2. Semi-strong efficiency:
   
   • prices adjust to all publicly available information very rapidly
3. Strong-form efficiency:
   
   • prices reflect all the information that any investor can acquire

Question 7

Explain Prospect Theory/loss aversion

Answer 7

1. Investors place different weights on gains and losses
2. More distressed by prospective losses than they are made happy by equivalent gains

Question 8

Explain Regret

Answer 8

1. less willing to sell a losing investment because it is showing a loss.