INVESTMENTS | BODIE, KANE, MARCUS Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter Thirteen Empirical Evidence on Security Returns

13-2 INVESTMENTS | BODIE, KANE, MARCUS 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

13-3 INVESTMENTS | BODIE, KANE, MARCUS Overview of Investigation

13-4 INVESTMENTS | BODIE, KANE, MARCUS The Index Model and the Single-Factor APT Expected Return-Beta Relationship Estimating the SCL

13-5 INVESTMENTS | BODIE, KANE, MARCUS 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”.

13-6 INVESTMENTS | BODIE, KANE, MARCUS 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

13-7 INVESTMENTS | BODIE, KANE, MARCUS 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

13-8 INVESTMENTS | BODIE, KANE, MARCUS Table 13.1 Summary of Fama and MacBeth

13-9 INVESTMENTS | BODIE, KANE, MARCUS 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.

13-10 INVESTMENTS | BODIE, KANE, MARCUS 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

13-11 INVESTMENTS | BODIE, KANE, MARCUS 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.

13-12 INVESTMENTS | BODIE, KANE, MARCUS Table 13.2 Evaluation of Various CAPM Specifications

13-13 INVESTMENTS | BODIE, KANE, MARCUS Table 13.3 Determinants of Stockholdings

13-14 INVESTMENTS | BODIE, KANE, MARCUS 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

13-15 INVESTMENTS | BODIE, KANE, MARCUS 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

13-16 INVESTMENTS | BODIE, KANE, MARCUS 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.

13-17 INVESTMENTS | BODIE, KANE, MARCUS Figure 13.1 CAPM vs FF Model

13-18 INVESTMENTS | BODIE, KANE, MARCUS Risk-Based Interpretations Style seems to predict GDP growth and relate to the business cycle. Liew and VassalouPetkova and Zhang When the economy is expanding, value beta < growth beta When the economy is in recession, value beta > growth beta

13-19 INVESTMENTS | BODIE, KANE, MARCUS Figure 13.2 Difference in Return to Factor Portfolios

13-20 INVESTMENTS | BODIE, KANE, MARCUS Figure 13.3 HML Beta in Different Economic States

13-21 INVESTMENTS | BODIE, KANE, MARCUS 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

13-22 INVESTMENTS | BODIE, KANE, MARCUS Figure 13.4 The Book-to-Market Ratio

13-23 INVESTMENTS | BODIE, KANE, MARCUS Figure 13.5 Value minus Glamour Returns Surrounding Earnings Announcements

13-24 INVESTMENTS | BODIE, KANE, MARCUS Momentum: A Fourth Factor T he 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.

13-25 INVESTMENTS | BODIE, KANE, MARCUS Liquidity and Asset Pricing Liquidity involves. –trading costs, –ease of sale, –necessary price concessions to effect a quick transaction, –market depth, –price predictability.

13-26 INVESTMENTS | BODIE, KANE, MARCUS 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.

13-27 INVESTMENTS | BODIE, KANE, MARCUS 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.

13-28 INVESTMENTS | BODIE, KANE, MARCUS 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.

13-29 INVESTMENTS | BODIE, KANE, MARCUS 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.

13-30 INVESTMENTS | BODIE, KANE, MARCUS Table 13.5 Annual Excess Returns and Consumption Betas

13-31 INVESTMENTS | BODIE, KANE, MARCUS Figure 13.7 Cross-Section of Stock Returns: Fama-French 25 Portfolios,

13-32 INVESTMENTS | BODIE, KANE, MARCUS 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.

13-33 INVESTMENTS | BODIE, KANE, MARCUS 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.

13-34 INVESTMENTS | BODIE, KANE, MARCUS 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.

13-35 INVESTMENTS | BODIE, KANE, MARCUS 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