Betas calculated purely based on historical data are unadjusted betas. However, this beta estimate based on historical estimates is not a good indicator of the future. This is also called the beta instability problem. Statistically, over time betas may exhibit mean reverting properties as extended periods significantly above 1 (one) may eventually decline and betas […]

# Portfolio Management L2

## Multifactor Models

While the Market Model uses only a single risk factor to price a security’s return, Multifactor Models apply a set of risk factors to describe an asset’s returns. Multifactor Model Types Macroeconomic Factor Models Apply economic variable as the risk factors that explain a security’s returns. Surprise Factor for betas of macroeconomic factor models: These […]

## Arbitrage Portfolio Theory (APT) – A Multifactor Macroeconomic Model

Arbitrage Portfolio Theory (APT) came along after CAPM as a multifactor model to explain returns. APT explains returns under the construct where: Multiple risks with an excess return above the risk free rate of return can be priced. Any security or portfolio has its own beta coefficient to each of the priced risk variables in […]

## Risk Factors and Tracking Portfolios

Tracking portfolios Tracking Portfolio: A portfolio assembled with securities that will replicate a specific risk profile. Tracking portfolios commonly mirror an expected benchmark index, such as an index of global large capitalization stocks. The theoretical construction of a tracking portfolio done through multifactor modeling is done by setting each factor sensitivities equal to the factor […]

## Markowitz, MPT, and Market Efficiency

Modern Portfolio Theory (MPT) is rooted in the mean-variance analysis research performed by Harry Markowitz conducted to allocate assets through a portfolio optimization process. The portfolio concepts presented in section I trace their roots to Markowitz groundbreaking work. The Efficient Market Hypothesis (EMH) contents that the market correctly prices all securities. MPT argues that all […]

## International Capital Market Integration

An efficient market is one, which is able to absorb new information into the security prices instantly. In the context of international markets, efficiency is not just about the individual markets but also about the pricing of these individual markets relative to the world index. The issue of international market efficiency revolves around international capital […]

## Domestic CAPM and Extended CAPM

Domestic CAPM An efficient market allows investors to diversify away company/security specific risk and have exposure solely to the market risk. The Capital Asset Pricing Model (CAPM) as previously discussed was considered purely from an investor’s domestic point of view. Domestic CAPM: Theoretic technique for an investor that can be used to price market/systemic risk […]

## Changes in Real Exchange Rates

Nominal Exchange Rates represent how many units of one currency can be exchanged for one unit of another currency. Nominal exchange rates are the rates quoted in the global markets for foreign currency exchange. Real Exchange Rates represent the amount of purchasing power in one currency can be exchanged for one unit of another currency. […]

## International CAPM (ICAPM) – Beyond Extended CAPM

The ICAPM attempts to explain the required return on a risky asset, measured in its own local currency. ICAPM assumption divergences from Extended CAPM The market basket for goods used in calculating CPI does not need to be the same goods, in the same percentages. Purchasing Power Parity does not always prevail. Theoretically, the ICAPM […]

## Measuring Currency Exposure

Currency exposures measure, in the investor’s domestic currency, an asset return’s sensitivity to returns on the ith/LC exchange rates. Currency exposure risk must be captured this way when the ICAPM is used to determine the domestic currency returns for a domestic investor purchasing a foreign asset. For example, if a Canadian investor wants to determine […]