Ec2723, Fall 2013: Q & A Notes

1. Is the market portfolio in the APT (in a single-factor model) the same as the market
portfolio in the CAPM?
Answer: In theory, No. This actually speaks to a more fundamental difference between
the CAPM and the APT: the former is an equilibrium model but the latter is not. Under the
CAPM, the market portfolio is the tangent portfolio, which is also mean-variance efficient.
Instead, in the APT with a single factor, the market can be any broadly diversified portfolio
that produces uncorrelated residual risks. In practice, however, people usually use some
typical market indexes to proxy the market portfolio in both models.
More fundamentally, the APT only requires no arbitrage and the fact that errors across
stocks are uncorrelated. It does not impose that investors always choose their portfolios
optimally, as required by the CAPM. In fact, the APT does not even require everybody to
recognize the arbitrage opportunity. Only a few deep-pocketed arbitrageur who are able to
take advantage of the arbitrage opportunities will ensure that no arbitrage holds.
2. Does the beta anomaly in stock returns (that is, the fact that the expected return of
high-beta stocks is too low relative to the CAPM prediction) provide evidence against the
efficient market hypothesis?
Answer: This is uncertain. With knowledge of the beta anomaly, investors can beat
the market by shorting high-beta stocks while longing low-beta stocks. Nevertheless, there
are two responses to this observation. On the one hand, it could be the case that the
market is inefficient. On the other hand, it could also be the case that our market model is
incorrect, and we should have used the Black CAPM instead. This is the joint hypothesis
problem, which implies that we can only test market efficiency and a given market model
jointly. Hence, we are not sure whether such evidence is really against the efficient market
hypothesis.
3. In Chapter 5, page 134, how can we derive condition (5.56) from condition (5.55)?
Answer: We use three approximations: 1) for small y, we have exp(y) 1 + y, 2) for
small y, we have y 3 0, and 3) unexpected log stock returns are approximately equal to
unexpected changes in log stock prices. Here it goes:
Et (1 + Rt+1 ) =

Dt+1
Pt
Dt+1
Pt
Dt+1
Pt
Dt+1
Pt

Vart (pt+1 pt )
+ exp(Et gt+1 ) exp
2
"
#
Vart (pt+1 pt )
+ exp(Et gt+1 ) 1 +
2
Vart (pt+1 pt )
+ exp(Et gt+1 ) + exp(Et gt+1 )
2
Vart (pt+1 pt )
+ exp(Et gt+1 ) + (1 + Et gt+1 )
2
1

Dt+1
Vart (pt+1 pt )
+ exp(Et gt+1 ) + (1 + Et gt+1 )
Pt
2
Dt+1
Vart (pt+1 pt ) Et gt+1 Vart (pt+1 pt )
=
+ exp(Et gt+1 ) +
+
Pt
2
2
|
{z
}
=

Vart (rt+1 )
Dt+1
+ exp(Et gt+1 ) +
.
Pt
2

4. In Chapter 6, page 160, between conditions (6.32) and (6.33) it says The dividend on the
wealth portfolio is aggregate consumption, and the expected return on the wealth portfolio is
a constant, plus expected consumption growth times (1/). How can we understand this?
Answer: This actually tells you how to derive (6.33) from (6.32). First, it says that
dw,t = ct ,
which helps you substitute dw,t+1+j out in (6.32). The second step is more tricky. Recall
condition (6.30) (on page 159), which says
rf,t+1 =

1
Et [ct+1 ] + const .

This comes from the Euler equation (6.29). Actually, for any risky asset, including the wealth
portfolio, this relation still holds, but with a different constant:
rw,t+1 =

1
Et [ct+1 ] + constw .

This will further help you substitute rw,t+1+j out in (6.32). Note that the constant will be
cancelled out when taking the expectation innovation between two time periods, as it is not
time-varying. This leads to (6.33) eventually.
5. We know that the coefficient relative risk aversion () is roughly in the range of 5 to 15.
How does the elasticity of intertemporal substitution (EIS, ) look like?
Answer: In the long-run risk model we know that we need > 1. However, in empirics,
we dont have a good consensus on this. In Lettau, Ludvigson and Wachter (2006) the
estimate of EIS () is larger than 1. But in an earlier paper by Vissing-Jorgensen (2002),
she found that the EIS for stockholders is in the range of 0.3 to 0.4, 0.8 to 1 for bondholders,
and larger for households with larger asset holdings within these two groups.
6. In the lecture notes for bonds, page 3, the first expression (as below) looks confusing.
What does it mean?
"
2

1 + Y1t = Et [1 + R2,t+1 ] = (1 + Y2t ) Et

1
1 + Y1,t+1

Answer: This follows the definition of the yield to maturity and the holding-period
return. The first term is the yield to maturity of a one-period bond, i.e., the return of
2

buying a one-period bond at t = 0 and holding it until maturity (t = 1). The second term is
the holding-period return of a two-period bond, i.e., the return of buying a two-period bond
at t = 0 and selling it at t = 1. The third term is the total return of buying a two-period
bond at t = 0 and holding it until maturity (t = 2), through issuing a one-period bond at
t = 1 to finance the position between t = 1 and t = 2. When the expectations hypothesis
holds, these three returns should be the same.
7. How can we test if risksharing is perfect?
Answer: This follows Cochrane (1991). Under full insurance, ct+1 should be crosssectionally independent of idiosyncratic variables. So we could run cross-sectional regressions
of ct+1 on a variety of exogenous variables and test if the coefficients are zero.