Chapter 13

To overcome CAPM testing difficulties:

A multifactor capital market usually is postulated. A broad market index (e.g. the S&P 500) represents one of the factors. Well diversified portfolios are often substituted for individual securities.

The research by Fama and French suggesting that CAPM is invalid has generated which of the following responses?

A) Theoretical sources and implications of research that contradicts CAPM needs to be reconsidered. B) Estimates of asset betas need to be improved. C) Better econometrics should be used in the test procedure. D) The single-index model needs to account for non-traded assets and the cyclical behavior of asset betas. E) All of the above are true.

Behavioral Explanations of the Equity Premium Puzzle

Barberis and Huang explain the puzzle as an outcome of irrational investor behavior.

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.

suppose you find, as research indicate, that in the cross ection regression of the CAPM, the coefficients of factor loadings on the FF model are significant predictors of average retun factors. explain

Even if the single-factor CCAPM (with a consumption-tracking portfolio used as the index) performs better than the CAPM, it is still quite possible that the consumption portfolio does not capture the size and growth characteristics captured by the SMB (i.e., small minus big capitalization) and HML (i.e., high minus low book-to-market ratio) factors of the Fama-French three-factor model. Therefore, it is expected that the Fama-French model with consumption provides a better explanation of returns than does the model with consumption alone.

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.

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".

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.

Tests 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

Which of the following is (are) a result(s) of the Fama and French (2002) study of the equity premium puzzle?

II) The reward-to-variability ratio (Sharpe) ratio derived from the DDM is far more stable than that derived from realized returns. III) Average realized returns during 1950-1999 exceeded the internal rate of return (IRR) for corporate investments.

Risk-Based Interpretations,

Liew and Vassalou Style seems to predict GDP growth and relate to the business cycle.

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.

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.

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: Replace individual assets with a set of portfolios with small nonsystematic components and widely spaced betas. Fama and MacBeth

explain rolls critique

Roll's critique suggests that the problem begins with the market index, which is not the theoretical portfolio against which the second pass regression should hold. Hence, even if the relationship is valid with respect to the true (unknown) index, we may not find it. As a result, the second pass relationship may be meaningless.

Liquidity and Efficient Market Anomalies

Sadka shows that the liquidity risk premium explains 40-80% of the abnormal returns to the momentum and postearnings announcement drift strategies.

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

Fama-French Three Factor Model

Size and book-to-market ratios explain returns on securities. Smaller firms experience higher returns. High book to market firms experience higher returns (value style). Returns are explained by size, book to market and by beta.

Interpretation of Three-Factor Model

Size and value are priced risk factors, consistent with APT. Alternatively, premiums could be due to investor irrationality or behavioral biases.

Which of the following statements is true about models that attempt to measure the empirical performance of the CAPM?

The conditional CAPM with human capital yields a better fit for empirical returns than the conventional CAPM.

specify the hypotheses for a test of the second pass regression for SML

The hypotheses for the second-pass • The intercept is zero; and, • The slope is equal to the average return on the index portfolio.

specify the hypothesis for a test of a second pass regression for the two factor SML

The intercept is zero; • The market-index slope coefficient equals the market-index average return; and, • The factor slope coefficient equals the average return on the factor. 12. The inputs for the second pass regression are: (Note that the first two hypotheses are the same as those for the single factor model.)

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.

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. Momentum may be related to liquidity.

Consumption Growth and Market Rates of Return

What matters to investors is not their wealth per se, but their lifetime flow of consumption.

Risk-Based Interpretations, Petkova and Zhang

When the economy is expanding, value beta < growth beta When the economy is in recession, value beta > growth beta

a high book-to-market ratio is associated with

a higher consumption beta

If a professionally managed portfolio consistently outperforms the market proxy on a risk-adjusted basis and the market is efficient, it should be concluded that:

either the CAPM is invalid or the proxy is inadequate.

The CAPM predicts

expected rates of return on assets, relative to a market portfolio of all risky assets.

The equity premium puzzle says :

historical excess returns are too high and/or our usual estimates of risk aversion are too low.

In the 1972 empirical study by Black, Jensen, and Scholes, they found that the estimated slope of the security market line was _______ what the CAPM would predict.

less than

An extension of the Fama-French three-factor model includes a fourth factor to measure ________.

momentum

In the results of the earliest estimations of the security market line by Lintner (1965) and by Miller and Scholes (1972), it was found that the average difference between a stock's return and the risk-free rate was ________ to its nonsystematic risk.

positively related

Strongest evidence in support of the CAPM has come from demonstrating that:

professional investors do not generally out-perform market indexes, demonstrating that the market is efficient.

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.

In the empirical study of a multi-factor model by Chen, Roll, and Ross, a factor that appeared to have significant explanatory power in explaining security returns was:

) the unexpected change in the rate of inflation. B) the risk premium on corporate bonds. C) industrial production.

According to Roll, the only testable hypothesis associated with the CAPM is:

whether the market portfolio is mean-variance efficient.

larger firm size is associated

with a lower consumption beta.