Chapter Thirteen
Empirical Evidence on Security
Returns
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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
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Overview of Investigation
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The Index Model and the
Single-Factor APT
• Expected Return-Beta Relationship
E ri rf i E rM rf
• Estimating the SCL
rit rft i bi rMt rft eit
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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”.
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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
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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
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Table 13.1 Summary of Fama and MacBeth
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Summary of CAPM Tests
1. Expected rates of return are linear and
increase with beta, the measure of
systematic risk.
2. Expected rates of return are not affected
by nonsystematic risk.
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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
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Human Capital and Cyclical Variations
in Asset Betas
• Jagannathan and Wang study shows two
important deficiencies in tests of the
single-index model:
1. Many assets are not traded, notably, human
capital. A human capital factor may be
important in explaining returns.
2. Betas are cyclical.
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Table 13.2 Evaluation of Various CAPM
Specifications
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Table 13.3 Determinants of Stockholdings
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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
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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
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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.
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Figure 13.1 CAPM vs FF Model
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Risk-Based Interpretations
Liew and Vassalou
• Style seems to
predict GDP
growth and
relate to the
business cycle.
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Petkova and Zhang
• When the economy
is expanding, value
beta < growth beta
• When the economy
is in recession,
value beta >
growth beta
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Figure 13.2 Difference in Return to Factor
Portfolios
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Figure 13.3 HML Beta in Different
Economic States
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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
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Figure 13.4 The Book-to-Market Ratio
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Figure 13.5 Value minus Glamour Returns
Surrounding Earnings Announcements
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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.
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Liquidity and Asset Pricing
• Liquidity involves.
– trading costs,
– ease of sale,
– necessary price concessions to effect a
quick transaction,
– market depth,
– price predictability.
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Liquidity and Asset Pricing
• Pástor and Stambaugh studied price
reversals.
• 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.
• Conclusion: Liquidity risk is a priced factor.
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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.
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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.
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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.
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Table 13.5 Annual Excess Returns and
Consumption Betas
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Figure 13.7 Cross-Section of Stock Returns:
Fama-French 25 Portfolios, 1954-2003
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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.
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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.
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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.
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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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