Empirical Evidence on Security Returns

1
Chapter 12
Empirical Evidence on Security Returns
2
Chapter Summary

• Objective To discuss the empirical evidence in
  support of equilibrium models.
• Tests of the Single Factor Model
• Tests of the Multifactor Model
• The Fama-French Three-Factor Model
• Other Studies

3
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

4
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

5
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

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Single Factor Test Results
7
Rolls 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

8
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

9
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.

10
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

11
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

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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

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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

14
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

15
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
• Fama, E.F. and K.R. French (1992) The
  Cross-section of Expected Stock Returns, Journal
  of Finance, 47, 427-486.
• Fama, E.F. and K.R. French (1993) Common Risk
  Factors in the Returns on Stocks and Bonds,
  Journal of Financial Economics, 33, 3-56.

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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

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The Davis, Fama and French Study (2000)

• The study sorted industrial firms annually by
  market capitalization and by book-to-market
  ratios
• The two size classes and three book-to-market
  classes formed six groups of firms
• Betas were estimated for each group by including
  a size factor and a book-to-market factor
• These factors had significantly positive
  coefficients
• Thus, small firms and high book-to-market firms
  earned higher returns

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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

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Stochastic Volatility

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

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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

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Figure 12.5 Estimates of the Monthly Stock Return
Variance 1835 - 1987
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Behavioral Explanations

• Market participants are overly optimistic
• Analysts extrapolate recent performance too far
  into the future
• Prices on these glamour stocks are overly
  optimistic
• Lower book-to-market on these glamour firms leads
  to underperformance compared to value stocks
• Chan, Karceski and Lakonishok
• LaPort, Lakonishok, Shleifer and Vishny

23
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

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Figure 12.9 Real Returns on Global Stock Markets