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Chapter 13

Chapter 13. Empirical Evidence on Security Returns. 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 . Tests of the Single Factor Model.

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Chapter 13

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  1. Chapter 13 Empirical Evidenceon Security Returns 13-1

  2. 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 13-2

  3. 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 13-3

  4. Return % Predicted Actual Beta Single Factor Test Results 13-4

  5. Roll’s Criticism • Only testable hypothesis is on the efficiency of the market portfolio • Benchmark error 13-5

  6. 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 13-6

  7. 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 13-7

  8. 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 13-8

  9. 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 13-9

  10. 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 13-10

  11. 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 13-11

  12. 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 13-12

  13. Stochastic Volatility • Stock prices change primarily in reaction to information • New information arrival is time varying • Volatility is therefore not constant through time 13-13

  14. 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 13-14

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