Amihud (2002)1 has developed an asset pricing model that accounts for liquidity risks.
a. In what ways liquidity potentially affect stock returns in your view?
b. Name three types of liquidity risks? How are they measured? How would these liquidity risks
incorporated into CAPM?
1
Amihud, Y. (2002). Illiquidity and stock returns: cross-section and time-series effects. Journal of financial markets, 5(1), 31-56.
Question based on week 3 topics due in week 4
T3Q1
Richard Roll, in an article on using the capital asset pricing model (CAPM) to evaluate portfolioperformance, indicated that it may not be possible to evaluate portfolio management ability ifthere is an error in the benchmark used.
a. In evaluating portfolio performance, describe the general procedure, with emphasis on the
benchmark employed.
b. Explain what Roll meant by the benchmark error and identify the specific problem with this
benchmark.
c. Draw a graph that shows how a portfolio that has been judged as superior relative to a
“measured” security market line (SML) can be inferior relative to the “true” SML.
d. Assume that you are informed that a given portfolio manager has been evaluated as superior
when compared to the Dow Jones Industrial Average, the S&P 500, and the NYSE Composite Index. Explain whether this consensus would make you feel more comfortable regarding the portfolio manager?s true ability.
e. Although conceding the possible problem with benchmark errors as set forth by Roll, some
contend this does not mean the CAPM is incorrect, but only that there is a measurement problem when implementing the theory. Others contend that because of benchmark errors the whole technique should be scrapped. Take and defend one of these positions. T3Q2
Bart Campbell, CFA, is a portfolio manager who has recently met with a prospective client, Jane Black. After conducting a survey market line (SML) performance analysis using the Dow Jones Industrial Average as her market proxy, Black claims that her portfolio has experienced superior performance. Campbell uses the capital asset pricing model as an investment performance measure and finds that Black?s portfolio plots below the SML. Campbell concludes that Black?s apparent superior performance is a function of an incorrectly specified market proxy, not superior investment management. Justify Campbell?s conclusion by addressing the likely effects of an incorrectly specified market proxy on both beta and the slope of the SML.
T3Q3Carefully read BKM10 Chapter 13, section 13.3 regarding Fama-French three factor model and answer the following questions:
a. What are the risk factors incorporated in the Fama and French three factor models? How are
they measured?
b. Why do we not subtract the risk-free rate from SMB or HML? Why do we subtract the risk-free rate from Rm ?
c. Subsequent to Fama and French?s (1993) finding, several academics have made effort in
interpreting the size and value effect. Their studies can be classified into two strands of literature: risk-based interpretation and behavioural based interpretation. List and briefly explain some studies under each strand.
d. Cahart (1997) incorporated a forth factor so called “momentum” into the Fama-French model.
Define “momentum” and describe how it is measured.
e. Suppose I sort some stocks by some characteristics to find new anomalies: Beta 0.84 0.89 0.93 0.98 1.04 1.09 1.12 1.19 Returns 0.45 0.62 0.8 0.99 1.16 1.45 1.48 1.72 Is there evidence to support the finding of a new ?anomaly? with respect to the CAPM?
T3Q4
Intercept MRP SMB HML 0.44019 0.79376 0.05243 -0.11812 -0.1488 1.1116 -0.1197 -0.3328 The above are coefficients estimates obtained by running the Fama-French three factor model on two different assets. One of the assets is a portfolio of stocks from the consumer goods industry, and another is a portfolio of stocks from the tech industry. Deduce which portfolio is which, given your knowledge of the differing characteristics of the two industries. T3Q5
Suppose you find, as research indicates, that in the cross-section regression of the CCAPM, thecoefficients of factor loadings on the Fama-French model are significant predictors of averagereturn factors (in addition to consumption beta). How would you explain this phenomenon? T3Q6
The following is an excerpt of a table replicated from The cross section of expected stock returns (Journal of Finance, Fama and French(1992)). Interpret the table and explain the manifestation of the ?value? effect and how this contradicts the CAPM (note relevant section of the table)
Questions based on week 4 topics due in week 5
T4Q1
The Generic Genetic(GG) Corporation pays no cash dividends currently and is not expected to for the next 3 years. Its latest EPS was $10, all of which was reinvested in the company. The firm's expected ROE for the next 3 years is 15% per year, during which time it is expected to reinvest all of its earnings. Starting in year 4, the firm's ROE on new investments is expected to fall to 12%, and the plowback ratio is 1/2, which it will continue to do forever after. The risk-free rate is 5%, the expected market return is 8%, and the stock of GG has a beta coefficient of 1.4. A competitor in the market trades with a price-earnings (PE) ratio of 16 in the market.
a. What is the intrinsic value of a share of GG stock based on DDM?
b. Do you think it is important to use multistage dividend discount model to value a firm? in
what circumstances? and does it have any limitations, eg. compared to FCFE model?
c. If a stock is underpriced, what is the relationship between market capitalization rate and its
expected rate of return?
d. What is the relative valuation of GG based on the PE ratio?
e. Comment on the differences in the estimated value of GG if any and the merits of each
method of valuation.
f. Assuming the company is the target of a hostile takeover and the acquirer is offering to pay
$165 for a share in GG. On the basis of your two calculations to value the firm should you accept the offer giving reasons for your recommendation? T4Q2.
Abbey Naylor, CFA, has been directed to determine the value of Sundanci's stock using Free Cash Flow to Equity(FCFE) model. Naylor believes that Sundanci's FCFE will grow at 25% for 2 years and 10% thereafter. Capital expenditures, depreciation, and working capital are expected to increase proportionately with FCFE.
a. Calculate the amount of FCFE per share for the year 2011, using data from Table 18A (BKM
10th edition, Chapter 18, page 628)
b. Calculate the current value of a share based on the two-stage FCFE model.
c. Describe one limitation of the two-stage DDM model that is addressed by using the two-stage
FCFE model
Describe one limitation of the two-stage DDM model that is not addressed by using the two-stage FCFE model T4Q3
Suppose you have made the following assessment for Company XYZ for four years: