Team member  Team manager: Lili Ma  Speaker: Liang Gao Chuan Sun  Technical support: Xiangyu Zheng Zhewei Gu

The Effects of Beta,Bid-Ask Spread,Residual Risk,and Size on Stock Returns YAKOV AMIHUD and HAIM MENDELSON

Background (i) Merton's Model According to the Capital Asset Pricing Model,expected asset returns are determined solely by the systematic risk. Inconsistencies between the dictum of the theory and the empirical findings led Merton to suggest a more general model of asset pricing.

The expected return on each asset will be as follows:  (1) an increasing function of its systematic risk;  (2) an increasing function of its residual risk (due to imperfect diversification of this risk);  (3) an increasing function of the fraction of the market portfolio invested in the asset, which can be measured by the asset's value or size;  (4) a decreasing function of the fraction of all investors who buy the asset, reflecting public availability of information about the asset. Expected return in Merton's Model

(ii) A-M's Model An asset-pricing model which focuses on the role of illiquidity, measured by the bid-ask spread, was suggested by Amihud and Mendelson. In this model, assets have bid-ask spreads which reflect their transaction (or illiquidity) costs, and investors have heterogeneous liquidation plans or holding periods.

(iii) The Bid-ask spread (1)The bid-ask spread is related to the number of investors holding the asset, by Merton, reflects the availability of information about it. (2)The bid-ask spread is also related to the residual risk.

(iv) The Main Task Carry out a well specified test of these relations jointly for all four explanatory variables.

2. Testing Hypothesis

Introduction to CAPM  Is the classical theory consistent with the empirical findings?

Probably Related Variables  —Portfolio Beta  —Portfolio Standard Deviation  —Portfolio Average Spread  —Average Market Value of Stocks in Portfolio  —Average Monthly Excess Return of Portfolio

Data & Methodology  Data Range:  Monthly series over 1961—1980  Methods  Using Pooled Cross-Section & Time-Series Estimation

Steps  1) Estimate stock’s coefficients from previous data using market model  2) Form 49 ptfs according to spread and then according to the value of  3) Calculate probably related variables of each ptf  4) Estimate cross-sectional relation

Results 1—Correlation

Results 2—Regression  DYn—Dummy Variables ( denoting the differences between the years)

Results 2—Significance  OLS Results

Results 3  GLS Results

Results 3  Principal factors affecting asset returns are the Beta risk and Illiquidity (Bid-ask Spread)  The hypotheses on the effects of size and residual risk are not supported

Contributions  Joint Estimation of effects of all four variables are superior to those obtained when a partial set of variables is included.

Conclusion Results support the hypotheses expected return is an increasing function of βand bid-ask spread but do not support the hypotheses on the effects of residual riskδand firm size

Conclusion  The effect of residual risk can be reduced by investor because of diversification but the effect of illiquidity is nondissipative because it is hardly eliminated by investors  firms have an incentive to increase the liquidity of their financial claims

 Thanks for your attention!  Thanks for our tutor- Peter N Smith!  Thanks for the time we’ve been together!  Thank you!