Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Chapter 10

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Chapter Summary  Objective: To discuss the empirical evidence in support of equilibrium models. Tests of the Single Factor Model Tests of the Multifactor Model Other Studies

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Overview of Investigation  Tests of the single factor CAPM or APT Model  Tests of the Multifactor APT Model Results are difficult to interpret  Studies on volatility of returns over time

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Tests of the Single Factor Model Tests of the expected return beta relationship  First Pass Regression Estimate beta, average risk premiums and unsystematic risk  Second Pass: Using estimates from the first pass to determine if model is supported by the data  Most tests do not generally support the single factor model

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Thin Trading  Many Canadian securities do not trade very frequently  This may cause biases in the statistical estimates  Several techniques exist to correct these biases

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Single Factor Test Results Return % Beta Predicted Actual

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Roll’s Criticism on the Tests  The only testable hypothesis: the mean- variance efficiency of the market portfolio  All other implications are not independently testable  CAPM is not testable unless we use the true market portfolio  The benchmark error

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Measurement Error in Beta Statistical property:  If beta is measured with error in the first stage,  Second stage results will be biased in the direction the tests have supported  Test results could result from measurement error

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Conclusions on the Tests’ Results  Tests proved that CAPM seems qualitatively correct Rates of return are linear and increase with beta Returns are not affected by nonsystematic risk  But they do not entirely validate its quantitative predictions The expected return-beta relationship is not fully consistent with empirical observation.

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Summary Reminder  Objective: To discuss the empirical evidence in support of equilibrium models. Tests of the Single Factor Model Tests of the Multifactor Model Other Studies

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Tests of the Multifactor Model Factors identified by Chen, Roll and Ross in their 1986 study:  Growth rate in industrial production  Changes in expected inflation  Unexpected inflation  Changes in risk premiums on bonds  Unexpected changes in term premium on bonds

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Study Structure & Results  Method: Two-stage regression with portfolios constructed by size based on market value of equity Findings  Significant factors: industrial production, risk premium on bonds and unanticipated inflation  Market index returns were not statistically significant in the multifactor model

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Anomalies Literature Is the CAPM or APT Model Valid?  Numerous studies show the approach is not valid  Why do the studies show this result Other factors influence returns on securities Statistical problems prohibit a good test of the model

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Summary Reminder  Objective: To discuss the empirical evidence in support of equilibrium models. Tests of the Single Factor Model Tests of the Multifactor Model Other Studies

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Fama and French Study (1992)  Size and book-to-market ratios explain returns on securities  Beta is not a significant variable when other variables are included  Study results show no support for the CAPM or APT

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Researchers’ Responses to Fama and French  Utilize better econometric techniques  Improve estimates of beta  Reconsider the theoretical sources and implications of the Fama and French- type results  Return to the single-index model, accounting for non-traded assets and cyclical behavior of betas

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Jaganathan and Wang Study (1996)  Included factors for cyclical behavior of betas and human capital  When these factors were included the results showed returns were a function of beta  Size is not an important factor when cyclical behavior and human capital are included

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Stochastic Volatility  Stock prices change primarily in reaction to information  New information arrival is time varying  Volatility is therefore not constant through time

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Stock Volatility Studies and Techniques  Pagan and Schwert Study Study of 150 years of volatility on NYSE stocks Volatility is not constant through time  Improved modeling techniques should improve results of tests of the risk- return relationship GARCH Models to incorporate time varying volatility

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Equity Premium Puzzle  Rewards for bearing risk appear too excessive  Possible causes: Unanticipated capital gains Survivorship bias  Survivorship bias also creates the appearance of abnormal returns in market efficiency studies