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Chapter Thirteen

This chapter provides an overview of empirical investigations into capital asset pricing models, including the Capital Asset Pricing Model (CAPM), the Arbitrage Pricing Theory (APT), and multifactor models. It covers tests of the expected return-beta relationship, measurement error in beta, Fama and MacBeth tests, the labor income factor, the Fama-French model, risk-based interpretations, behavioral explanations for value premiums, momentum as a fourth factor, liquidity and asset pricing, and the equity premium puzzle.

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Chapter Thirteen

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  1. Chapter Thirteen Empirical Evidence on Security Returns

  2. Overview of Investigation • Capital Asset Pricing Models consist of two parts: • 1. Optimal P derivation based on risk tolerance and input list • 2. Derive predictions about expected returns in equilibrium

  3. Overview of Investigation

  4. The Index Model and the Single-Factor APT • Expected Return-Beta Relationship • Estimating the SCL

  5. Tests of the CAPM Tests of the expected return beta relationship: • First Pass Regression • Estimate beta, average risk premiums and nonsystematic risk • Second Pass • Use estimates from the first pass to see if model is supported by the data • SML slope is “too flat” and intercept is “too high”.

  6. Roll’s Criticism • The only testable hypothesis is whether the market portfolio is mean-variance efficient. • Sample betas conform to the SML relationship because all samples contain an infinite number of ex post mean-variance efficient portfolios. • CAPM is not testable unless we know the exact composition of the true market portfolio and use it in the tests. • Benchmark error due to proxy for M

  7. Measurement Error in Beta • Problem: If beta is measured with error, then the slope coefficient of the regression equation will be biased downward and the intercept biased upward. • Solution: Construct P with large dispersion of beta. Then, by ranking them, they yield insightful tests of the SML • Fama and MacBeth

  8. Table 13.1 Summary of Fama and MacBeth

  9. Summary of CAPM Tests • Expected rates of return are linear and increase with beta, the measure of systematic risk. • Expected rates of return are not affected by nonsystematic risk.

  10. Tests of the Multifactor CAPM and APT • Three types of factors likely the augment market risk factor: • Factors that hedge consumption against uncertainty in prices • Factors that hedge future investment opps. • Factors that hedge assets missing from market index (labor income) • Labor income- Mayers model creates wedge between betas, resulting in SML flatter than CAPM’s

  11. Human Capital and Cyclical Variationsin Asset Betas • Jagannathan and Wang study shows two important deficiencies in tests of the single-index model: • Many assets are not traded, notably, human capital. A human capital factor may be important in explaining returns. • Betas are cyclical.

  12. Table 13.2 Evaluation of Various CAPM Specifications

  13. Table 13.3 Determinants of Stockholdings

  14. Early Versions of the Multifactor Model Chen, Roll and Ross 1986 Study Factors • Growth rate in industrial production • Changes in expected inflation • Unexpected inflation • Unexpected changes in risk premiums on bonds • Unexpected changes in term premium on bonds

  15. Study Structure & Results • Method: Two-stage regression with portfolios constructed by size based on market value of equity • Significant factors: industrial production, risk premium on bonds and unanticipated inflation • Market index returns were not statistically significant in the multifactor model

  16. Fama-French-Type Factor Models • Size and book-to-market ratios explain returns on securities. • High book to market firms experience higher returns (value style). • Smaller firms experience higher returns. • FF quantifies the size risk premium • Size and value are priced risk factors, consistent with APT.

  17. Figure 13.1 CAPM vs FF Model

  18. Liew and Vassalou Petkova and Zhang Risk-Based Interpretations • Style seems to predict GDP growth and relate to the business cycle. When the economy is expanding, value beta < growth beta When the economy is in recession, value beta > growth beta

  19. Figure 13.2 Difference in Return to Factor Portfolios

  20. Figure 13.3 HML Beta in Different Economic States

  21. Behavioral Explanations for Value Premium • “Glamour firms” are characterized by recent good performance, high prices, and lower book-to-market ratios. • High prices reflect excessive optimism plus overreaction and extrapolation of good news. • Chan, Karceski and Lakonishok • LaPorta, Lakonishok, Shleifer and Vishny

  22. Figure 13.4 The Book-to-Market Ratio

  23. Figure 13.5 Value minus Glamour Returns Surrounding Earnings Announcements

  24. Momentum: A Fourth Factor • The original Fama-French model augmented with a momentum factor has become a common four-factor model used to evaluate abnormal performance of a stock portfolio. • Winners minus losers (WML)- winners/losers based on past returns.

  25. Liquidity and Asset Pricing • Liquidity involves. • trading costs, • ease of sale, • necessary price concessions to effect a quick transaction, • market depth, • price predictability.

  26. Liquidity and Asset Pricing • Pástor and Stambaugh studied price reversals. • Conclusion: Liquidity risk is a priced factor. Price reversals may occur when traders have to offer higher purchase prices or accept lower selling prices to complete their trades in a timely manner.

  27. Equity Premium Puzzle The equity premium puzzle says : • historical excess returns are too high and/or • our usual estimates of risk aversion are too low.

  28. Consumption Growth and Market Rates of Return • What matters to investors is not their wealth per se, but their lifetime flow of consumption. • Measure risk as the covariance of returns with aggregate consumption.

  29. Consumption Growth and Market Rates of Return • The lower panel of Table 13.5 shows: • a high book-to-market ratio is associated with a higher consumption beta • larger firm size is associated with a lower consumption beta.

  30. Table 13.5 Annual Excess Returns and Consumption Betas

  31. Figure 13.7 Cross-Section of Stock Returns: Fama-French 25 Portfolios, 1954-2003

  32. Expected versus Realized Returns • FF- • Found an equity premium only after 1949 • Capital gains significantly exceeded the dividend growth rate in modern times. • Equity premium may be due to unanticipated capital gains.

  33. Survivorship Bias • Estimating risk premiums from the most successful country and ignoring evidence from stock markets that did not survive for the full sample period will impart an upward bias in estimates of expected returns. • The high realized equity premium obtained for the United States may not be indicative of required returns.

  34. Liquidity and the Equity Premium Puzzle • Part of the equity premium is almost certainly compensation for liquidity risk rather than just the (systematic) volatility of returns. • Ergo, the equity premium puzzle may be less of a puzzle than it first appears.

  35. Behavioral Explanations of the Equity Premium Puzzle • Barberis and Huang explain the puzzle as an outcome of irrational investor behavior. • The premium is the result of narrow framing and loss aversion. • Investors ignore low correlation of stocks with other forms of wealth • Higher risk premiums result

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