The Dichotomous Asset Pricing Model Evidence from the UK market 1. Introduction Ever since its introduction by Sharpe-Lintner-Black, the Capital Asset Pricing Model (CAPM) has been subject to criticism, appraisal and continuous efforts for improvement, such as the Reward Beta approach (Bornholt, 2007), conditional CAPM or the consumption CAPM. The Dichotomous Asset Pricing Model (DAPM), introduced by Professor Liang Zou at the Universiteit van Amsterdam, brings a fresh approach to asset pricing and contributes significantly to enhancing the over-disputed CAPM. The model manages to combine mean-variance (MV) and the gain-loss (GL) approaches to portfolio selection and asset pricing by proving that a benchmark portfolio is MV and GL efficient if and only if a dichotomous asset pricing model holds. More precisely, the DAPM holds if for all assets i the following predictions are satisfied, in relation to a benchmark portfolio m: The model was so far tested and compared to the CAPM and best-beta CAPM (BCAPM) on the Fama-French 100 portfolios sorted on size and value, with significant insights. The aim of this paper is to repeat the analysis and test the predictive power of the DAPM for a European market, more precisely to answer the following question: Does DAPM hold for the UK stock market? UK market was chosen because of its size and trading volumes, but also because it bears most resemblances to the US one. This way, we are more prone to obtaining comparable results for the two markets. In particular, in order to answer the above question, the following hypotheses are tested: , for each individual stock i and

, for the cross section regression, where the benchmark portfolio is the market portfolio m. 2. Background and predictions The analysis performed by professor Zou on the Fama-French 100 portfolios sorted on size and value proves the superior predictive power of the DAPM, both over the BCAPM and the CAPM. The results can be summarized as follows: ,,i2,H1:...

...Running head: PRICINGMODELSPricingModels
Adam F. Thornton
FIN 501 – 3
TUI University
Dr. William Anderson
Chipotle Mexican Grill (CMG) is one of the fastest growing restaurant chains in the United States. Self proclaimed as “fast-casual,” CMG offers a dining experience that is unique, organic, and which draws from the local economy. For the investor, CMG is a wise investment for the aggressive and fast growing portion of a portfolio. When determining an appropriate model to evaluate CMG’s potential, the Capital AssetPricingModel (CAPM) is the best choice. This model offers the best amount detail while maintaining the simplicity needed for a model outlining investment decisions in CMG.
The PricingModels
There are three pricingmodels to discuss when evaluating CMG: dividend growth, CAPM, and the Arbitrage Pricing Theory (APT). Each of these models has both advantages and disadvantages, easily tailoring one model to different situations. However, the CAPM is best suited for this case with CMG. Below is a further review on each of models’ advantages and disadvantages, and applicability to CMG’s market position and financial situation.
The Gordon Growth...

...Capital AssetPricingModel
The Capital AssetPricingModel otherwise know as CAPM defines the relationship between risk and return for individual securities. William Sharpe published the capital assetpricingmodel in 1964. CAPM extended Harry Markowitz's portfolio theory to introduce the notions of systematic and specific risk. For his work on CAPM, Sharpe shared the 1990 Nobel Prize in Economics with Harry Markowitz and Merton Miller
CAPM assumes the concept of a logical investor, assumes a perfect market, and uses a measure of investment risk known as a Beta. When CAPM assumes these three concepts above there has to be a definition to describe the assumptions.
Therefore when we assume a logical investor we are actually referring to an investor that makes his or her investments based upon the expectation of a return. Investors will anticipate their return by analyzing the stock market's average rate of return and that will be their expectation when looking into a specific security. If they are not going to anticipate their return to equal the markets average rate of return then there will be no reason to invest. You invest to make a profit. Investors invest to make a profit. Furthermore a logical investor accepts the market rate of risk. Since they are anticipating the average market rate of return they also have to be willing to...

...1. For each of the scenarios below, explain whether or not it represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
Undiversifiable (market )risk:
Market risk is the variability in all risky assets caused by macroeconomic variables. This risk cannot be avoided, regardless of the amount of diversification. Systematic risk (Market risk) factors are those macroeconomic variables that affect the valuation of all risky assets such as variability in the growth of the money supply, interest rate volatility, variability in aggregate industrial production, and natural shocks like drought, earth quake, hurricane, etc.
Diversifiable (unique )risk:
Many of the risks faced by an individual company are peculiar to its activity, its management, etc. These are the unique risks and can be diversified away. Examples of unique risks are a company winning a large contract, wildcat strikes hitting a company, litigation hitting a company or the company facing a governmental investigation.
a. A large fire severely damages three major U.S. cities.
Diversifiable risk
The entire economy will not be affected by a large fire in three major US cities. In fact some companies in cities not affected by fire will benefit as they will meet the demand not being met by companies in the three cities that are...

...Chapter 9: Multifactor Models of Risk and Return. (QUESTIONS)
1. Both the capital assetpricingmodel and the arbitrage pricing theory rely on the proposition that a no-risk, no-wealth investment should earn, on average, no return. Explain why this should be the case, being sure to describe briefly the similarities and differences between CAPM and APT. Also, using either of these theories, explain how superior investment performance can be establish.
Answer:
Both the Capital AssetPricingModel and the Arbitrage PricingModel rest on the assumption that investors are reward with non-zero return for undertaking two activities:
(1) committing capital (non-zero investment); and (2) taking risk. If an investor could earn a positive return for no investment and no risk, then it should be possible for all investors to do the same. This would eliminate the source of the “something for nothing” return.
In either model, superior performance relative to a benchmark would be found by positive excess returns as measured by a statistically significant positive constant term, or alpha. This would be the return not explained by the variables in the model.
2. You are the lead manager of a large mutual fund. You have become aware that several equity analysts who have recently joined your management team are...

... explain whether or not it represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
a. There's a substantial unexpected increase in inflation.
b. There's a major recession in the U.S.
c. A major lawsuit is filed against one large publicly traded corporation.
2. Use the CAPM to answer the following questions:
a. Find the Expected Rate of Return on the Market Portfolio given that the Expected Rate of Return on Asset "i" is 12%, the Risk-Free Rate is 4%, and the Beta (b) for Asset "i" is 1.2.
b. Find the Risk-Free Rate given that the Expected Rate of Return on Asset "j" is 9%, the Expected Return on the Market Portfolio is 10%, and the Beta (b) for Asset "j" is 0.8.
c. What do you think the Beta (β) of your portfolio would be if you owned half of all the stocks traded on the major exchanges? Explain.
3. In one page explain what you think is the main 'message' of the Capital AssetPricingModel to corporations and what is the main message of the CAPM to investors?
1. For each of the scenarios below, explain whether or not it represents a diversifiable or an un-diversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
a. There’s a substantial unexpected increase in inflation.
Un-diversifiable risk
The entire economy will...

...Capital AssetPricingModel (CAPM): Pros and Cons.
CAPM defines the relationship between risk and return. The premise of the model is that the expected investment return varies in direct proportion to its risk, i.e., the riskier the investment - the higher the return you should expect.
Shows:
• how much risk you are taking when investing in an instrument?
• whether the instrument is rightly priced
• whether you are getting sufficient return for the risk you are taking
CAPM calculates the risk-adjusted discount rate with the risk-free rate, the market risk premium, and beta (mathematical formula):
Return (R) = Rf + beta x (Rm - Rf)
Rf is the rate of risk-free investments
Beta - the risk of loss associated with your investments.
Rm is the expected market return.
(Rm-Rf) – market risk premium
beta x (Rm - Rf) – risk premium of specific company
Investments are good if the expected return from the investment equals/exceeds required return.
Market Risk Premium [Rm-Rf]
The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk
Its size depends on the perceived risk of the overall stock market and investors’ degree of risk aversion
Varies across time. Usually ranged between 4-8%
BETA in CAPM measures a stock’s degree of systematic or market risk. It can also be thought of as the stock’s contribution to the risk of a well-diversified...

...CAPITAL ASSETPRICINGMODEL
The Capital AssetPricingModel deals with independent investor problems that needs to undergo the procedure of selection of securities involving risks. The investors need to select the most advantageous security that produces the best possible outcome. This model deals with the estimation of securities as well as it links the risk and return (the expected shares). There is a direct relationship and risk and return provides higher expected return from that security. CAPM is considered the key model for helping in decision making regarding the selection of securities and also helps in planning the strategies.
Types Of Risks – The unsystematic or the diversifiable risk is related to the haphazard causes which can be eradicated or removed with the help of diversification. Similarly the systematic or the non-diversifiable risk is related to the factors of the market which cannot be removed with the help of diversification. The permutation of both the risks is the total risk. The investors choose the systematic risk over the unsystematic as it helps the investors in the selection of the assets.
The derivation of the Capital AssetPricingModel has taken place with the assumption of indirect symmetry in the returns from the assets. This basically shows that the...

...University of Macau Faculty of Business Administration MFIN604 – Theory of Finance MSc in Finance (Fall 2012/13) Instructor: Prof. Keith Lam (Associate Professor of Finance) Office: L217 (Ext. 4167) Email: keithlam@umac.mo Webpage (intranet): http://personalweb.umac.mo/keithlam Course Objectives The course aims to provide students with solid theoretical frameworks in assetpricing and other fields of finance. For assetpricing, the concepts of risk and return, and state prices will be introduced as a stepping stone towards the discussions of more advanced topics including the Capital AssetPricingModel (CAPM), the Arbitrage Pricing Theory (APT), and other more recent assetpricingmodels. Other topics in finance such as options and behavior finance may also be covered on an optional basis. Besides the theoretical frameworks, recent developments in empirical assetpricing and empirical finance will also be covered with an extensive use of academic research papers. (Pre-requisite: Principles of Accounting) Textbook 1. Elton, Edwin, Martin Gruber, Stephen J. Brown , and William Goetzmann, Modern Portfolio Theory and Investment Analysis, 8th Edition, John Wiley, 2011. Reference books: 1. Copeland, T.E., Weston, J.F., and Shastri, K. (CWS), Financial Theory and Corporate Policy, 4th edition,...