Question

Week 8: Factor Models Concept Objective Learn the differences between the CAPM and the APT. Instructions i) draw the SML and include one asset that is underpriced. ii) Explain how mispricings vanish in equilibrium according to the CAPM. ill) Explain how mispricings vanish according to the APT. Rubric Level 1 (Worst) Level 2 Level 3 Level 4 Novice Intermediate Proficient Advanced Organization No clear sequence Material Material explained in a Material explained in a explained/presented in logical manner logical, sophisticated a confusing manner and engaging manner Knowledge of Displays little/no Displays thorough Displays some understanding of the Displays sufficient understanding of the Content understanding of understanding of the concept concepts. Leaves concept content. Extra research is evident important information out Correctness Final answer and Final answer might be intermediate steps are Final answer and some of the intermediate steps are incorrect incorrect but most Everything is correct, both the final answer and all intermediate incorrect. intermediate steps are correct. steos. Your Creation Evaluations Feedback

Answer 1

Answer to Instruction(i)

Drawing SML with display of an asset that is underpriced is as follows:

Estimated Return Beta

Here Y axis is represented as Estimated return and X axis is represented as Beta. Rf stands for Risk free rate of return. The line drawn from Rf represents SML. The security that is shown in the line represents L it states that estimated return and expected return on security L is identical.

whereas the security A plotted above the SML states that its estimated return is higher than expected return. It means that it is offering higher return than what is commensurate its risk. Hence it is attractive and presumed to be underpriced. So security A is underpriced.

Answer to instruction(ii)

The mispricings vanish according to CAPM based on its assumption:

1) Investors are rational

2) All informations are readily reflected in the stock price

3) There is no transaction cost

These assumptions would help to vanish mispricings of securities in the market place.

Answer to instruction(iii)

In Arbitrage Pricing Theory (APT) mispricings are vanished through identification of undervalued portfolios. Once the undervalued portfolios are identified, the investors would purchase these undervalued portfolios by selling the indexed portfolios which are overvalued. As all investors engage in this process of selling overvalued portfolios and buying of undervalued portfolios this would help to drive away the arbitrage profit if any, i.e mispricing of securities. This is the methodology of APT in vanishing mispricing of securities.