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Chapter 10. Empirical Evidence on Security Returns. 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. Overview of Investigation.

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Chapter 10

Empirical Evidence on Security Returns

chapter summary
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
overview of investigation
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
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
thin trading
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
roll s criticism on the tests
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
measurement error in beta
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
conclusions on the tests results
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.
summary reminder
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
tests of the multifactor model
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
study structure results
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
anomalies literature
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
summary reminder1
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
fama and french study 1992
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
researchers responses to fama and french
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
jaganathan and wang study 1996
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
stochastic volatility
Stochastic Volatility
  • Stock prices change primarily in reaction to information
  • New information arrival is time varying
  • Volatility is therefore not constant through time
stock volatility studies and techniques
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
equity premium puzzle
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