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Empirical Evidence On Security Returns

The document discusses empirical tests of the capital asset pricing model (CAPM) and arbitrage pricing theory (APT). It summarizes several studies that tested single-factor and multifactor models. While most tests did not support the single-factor CAPM, the Chen, Roll and Ross study found a multifactor APT using factors like industrial production and inflation explained returns better. However, Fama and French found firm size and book-to-market ratios explained returns more than beta. Later studies attempted to improve on these mixed results.

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69 views

Empirical Evidence On Security Returns

The document discusses empirical tests of the capital asset pricing model (CAPM) and arbitrage pricing theory (APT). It summarizes several studies that tested single-factor and multifactor models. While most tests did not support the single-factor CAPM, the Chen, Roll and Ross study found a multifactor APT using factors like industrial production and inflation explained returns better. However, Fama and French found firm size and book-to-market ratios explained returns more than beta. Later studies attempted to improve on these mixed results.

Uploaded by

z_k_j_v
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Bodie

Kane

Marcus

INVESTMENTS
Fourth Edition

Chapter 13

Empirical Evidence
on Security Returns
The McGraw-Hill Companies,

Bodie

Kane

Marcus

INVESTMENTS
Fourth 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

The McGraw-Hill Companies,

Bodie

Kane

Marcus

INVESTMENTS
Fourth 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
The McGraw-Hill Companies,

Bodie

Kane

Marcus

INVESTMENTS
Fourth Edition

Single Factor Test Results


Return %
Predicted
Actual

Beta
The McGraw-Hill Companies,

Bodie

Kane

Marcus

INVESTMENTS
Fourth Edition

Rolls Criticism
Only testable hypothesis is on the efficiency
of the market portfolio
Benchmark error

The McGraw-Hill Companies,

Bodie

Kane

Marcus

INVESTMENTS
Fourth 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

The McGraw-Hill Companies,

Bodie

Kane

Marcus

INVESTMENTS
Fourth Edition

Tests of the Multifactor Model

Chen, Roll and Ross 1986 Study

Factors
Growth rate in industrial production
Changes in expected inflation
Unexpected inflation
Changes in risk premiums on bonds
Unexpected changes in term premium on bonds

The McGraw-Hill Companies,

Bodie

Kane

Marcus

INVESTMENTS
Fourth 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

The McGraw-Hill Companies,

Bodie

Kane

Marcus

INVESTMENTS
Fourth 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

The McGraw-Hill Companies,

Bodie

Kane

Marcus

INVESTMENTS
Fourth Edition

Fama and French Study


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

The McGraw-Hill Companies,

Bodie

Kane

Marcus

INVESTMENTS
Fourth 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 nontraded assets and cyclical behavior of
betas

The McGraw-Hill Companies,

Bodie

Kane

Marcus

INVESTMENTS
Fourth Edition

Jaganathan and Wang Study


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

The McGraw-Hill Companies,

Bodie

Kane

Marcus

INVESTMENTS
Fourth Edition

Stochastic Volatility
Stock prices change primarily in reaction to
information
New information arrival is time varying
Volatility is therefore not constant through
time

The McGraw-Hill Companies,

Bodie

Kane

Marcus

INVESTMENTS
Fourth 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
The McGraw-Hill Companies,

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