The Inefficient Stock Market What Pays Off and Why by Robert A. Haugen

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The Inefficient Stock MarketWhat Pays Off and
WhybyRobert A. Haugen

• CHAPTER 2
• ESTIMATING EXPECTED RETURN WITH THE THEORIES OF
  MODERN FINANCE

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K. Hartviksen
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REMEMBER

• When Haugen uses the term beta his is most
  often describing a coefficient developed
  through simple or multiple regression techniques.
• I like to only use the term beta to describe the
  coefficient that is used in the CAPM to measure
  systematic risk.
• This helps us to make clear what it is we are
  discussing.

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Chapter 2 - Modern Finance

• Modern finance is founded on the assumption that
  risk is the only explanatory variable that
  determines expected return in investments.
• CAPM has a number of assumptions (please see
  Chapter 3 of the Farrell text for a full and
  balanced discussion of the assumptions of the
  CAPM)but Haugen concentrates on the critical
  assumption that all investors use Markowitzs
  optimization in their selection of their
  portfolios.
• Haugen hits the CAPM hard with this unrealistic
  assumptionand the assumption that investors face
  no limits on their ability to borrow to invest or
  to short stock.

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Chapter 2 - Modern Finance

• CAPM Criticisms
• there is ample evidence that investors do not use
  Markowitz portfolio optimization
• investors do not have unlimited ability to
  leverage their investments at the risk-free rate
  of returnor to unlimited short sales
• skewness of probability distributions of expected
  returns is not measured in the pure mean-variance
  frameworkand so two equal securities according
  to Markowitz would not be viewed equal from an
  investors point of view
• Continued ...

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Chapter 2 - Modern Finance

• CAPM Criticisms
• there is ample evidence that investors do not use
  Markowitz portfolio optimization
• fiduciaries (professional money managers) in
  addition to the above, view their performance
  relative to a benchmark (see Chapter 15 of the
  Farrell text)this is their risk-free asset.
• CONCLUSION - no one uses the Markowitz
  approachso the markets cant behave as if they
  do.

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Chapter 2 - Modern Finance

• Arbitrage Pricing Theory
• Haugen now turns his attention to the APT, which
  is the much heralded successor to the
  CAPM.(ie. it is a new and improved theory).
• Whereas the CAPM is a single-factor model, the
  APT can use many different coefficients to
  measure the return implications for many
  different kinds of risk.
• APT does this by regressing historical returns
  against economic factors such as interest rates,
  inflation or industrial productionthe slope of
  the regression lines (beta) gives you a measure
  of the sensitivity of returns to those economic
  factors.

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Chapter 2 - Modern Finance

• Arbitrage Pricing Theory
• stocks can have inflation betas, oil price betas,
  etc.
• Haugen now attacks the APT on the basis that
  those coefficients assume a linear relationship
  between returns and the economic risk factor.
• Because of the law of one price.the relationship
  has to be linear.by definition.the only
  prediction of APT is that the relationship
  between return and the risk factor must be
  linear.
• APT doesnt predict which factors are going to be
  important, it doesnt tell us if the linear
  relationships should be positively sloped or
  negatively sloped.

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Chapter 2 - Modern Finance

• Arbitrage Pricing Theory
• hedge fund managers try to exploit the curvature
  inefficiencies identified by APThowever, the
  extra return associated with curvature is likely
  to be tiny relative to the out-of-sample risk you
  take in attempting to arbitrage..such managers
  go long and short, trying to capture spreads in
  expected returns while trying to minimize
  variability in the net return.a very difficult
  task.and a very risky game.
• Haugen predicts Play the APT game, and youll
  first go hungry and then go bust.

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Chapter 2 - Modern Finance

• Be Sure You Know
• what an efficient portfolio is
• the meaning of tracking error
• what is arbitrateand how the APT got its name
• what a hedge fund attempts to do
• left and right skewness
• the critical assumptions of both the CAPM and APT
• the Haugen criticisms of both models

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K. Hartviksen