You test your hedge fund\' s performance using the CAPM. The results have the fo

Question

You test your hedge fund' s performance using the CAPM. The results have the following characteristics: Alpha Beta Coefficient 0.5 1.25 p-value 0.01 0.03 a. Does the fund generate alpha? Should alpha exist in perfectly efficient markets? b. Is the fund sensitive to fluctuations in the market? c. What are the main implications of the CAPM, if it is true? d. How can we improve on the CAPM? In other words, what can be added to the CAPM to allow it to be a more complete model? e. Write down and describe the Fama-French asset pricing model. What factor did Carhart add to improve the model? f. What issues specific to alternative investments can impact our ability to use traditional asset pricing models?

Explanation / Answer

a) Yes, the fund Generates alpha as alpha coefficient is positive and significant at 95% level (p-value<0.05). Alpha shall not exist in a perfect world because markets are efficient and there shall not be any gains above an assets intrinsic value.

b) Yes, the fund is sensiitive to market fluctuations as beta is more than 1 (1.25) and is also significant.

c)Implications of CAPM are:

d) CAPM can be improved by adding a number of factors that may account for standalone risk of a firm. It can be improved by adding change in beta over time or adding up sectoral beta for a company. Over years many models have been proposed and work better than CAPM, but CAPM is the base of all models.

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