Alternative View of Risk and Return

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Alternative View of Risk and Return
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Multi Factor Pricing Models

• Like CAPM, an assets return is related to common
  risks
• But we now allow for their to be more than a
  single source of risk
• Oil

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Example Fama French Model

• Returns are a function of three risk factors
• Size factor
• Return on the averages small firm minus the
  average large firm
• Value factor
• Return on the average value firm minus the
  average growth firm
• Market Factor
• Same as CAPM

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Multi-Factor Betas

• Since we are allowing for multiple risk factors,
  how will b change?
• i refers to the individual stock
• j refers to the source of risk
• ßi,j ?i,j / ?j2
• It DOESNT

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Example

• What is a stocks expected return if its betas
  are
• SML 0.5
• HML 3.0
• Mkt 2.0
• SML is 8, HML is 5, the market risk premium is
  4, and the risk free rate is 3
• R 0.03 0.50.08 30.05 20.04
• R 30

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Why We Care

• Another investment rule which is commonly used
• Provides another viewpoint regarding how returns
  are generated

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Market Efficiency
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News and Returns

• All news, and announcements contain anticipated
  and unexpected components
• The market prices assets based on what is
  expected to happen (Anticipated news)
• Changes in expectations will cause the price to
  move
• Unexpected news is a surprise and will cause
  prices to move
• Surprises cause unexpected returns

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Breaking Returns Down

• A securitys return is comprised of
• The expected return, based on expectations
• The un-expected return, based on surprises
• Therefore, a stocks return is

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Where does U come from?

• Systematic Surprises
• Difference between what we expect our factor to
  do and what actually happens
• Ex Market goes up 10 when expected 7
• Unique Surprises
• Unanticipated events
• Ex CEO dies

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Breaking Returns Down (2)

• We defined returns as
• We can break U down further
• is the return earned because of unexpected
  movements in systematic risk
• is the return from unique surprises

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Example

• Lets use the Fama French factors
• SML, HML, and Mkt
• Our model is

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Surprises

• Expected SML to be 3, but it was 8 surprise
  is?
• 0.08 0.03 5
• Expected HML to be 4, but it was 1 surprise
  is?
• 0.01 0.04 -3
• Expected Mkt to be 10, but it was stable
  surprise is?
• 0.00 - 0.10 -10
• Finally, the firm attracted a superstar CEO,
  and this unanticipated development contributes 1
  to the return.

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Example Betas

• The stocks betas are
• bSML -2.30
• bHML 1.50
• bMkt 0.50
• The stocks expected return is 8

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Examples Actual Return
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Underlying Assumption

• The assumption we made, and that drove the last
  example, is that the stock is priced in an
  efficient market

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What is an efficient market?

• A market is efficient when it uses all available
  information to price assets.
• Information is quickly incorporated into prices
• Efficiency is the degree to which prices reflect
  available information.
• Stock prices only respond to surprises, which
  arrives randomly, so prices follow a random walk
• Price tomorrow todays price random (/-)

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Price Today and Tomorrow
Do you see a pattern that you want to put money
on?
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Reactions to Beating Expectations
Over Reaction
Under Reaction
Efficient Response
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Reaction to Not Meeting Expectations
Under Reaction
Efficient Reaction
Over Reaction
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Potential Causes of Efficient Markets

• Investor Rationality
• Everyone is rational ? Everyone makes the right
  decision
• Independent Deviation from Rationality
• No one is rational ? Everyone makes the wrong
  decision but each makes a different wrong
  decision
• Average out the wrongness
• Arbitrage
• Only some people are rational ? Smart money takes
  from less smart money

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Types of Efficient Markets
Strong
Semi-Strong
Weak
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Weak Form Efficiency

• Prices reflect all information contained in past
  prices and volumes
• No investor is able to form a trading strategy
  based on historic prices and volumes and earn an
  excess return

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Disbelievers

• Chartists, or Technical Analysts
• Analyze charts of a stocks Price and/or Volume
• Chartist believe in identifiable and predictable
  patterns in these characteristics
• Make investment decisions based on these patterns
• Brokerage firms tend to love chartists

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Head and Shoulders
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Why Technical Analysis Fails
Stock Price
-If there is a profitable pattern, everyone would
do it -If everyone follows the same strategy
competition will eliminate any opportunity
associated with the pattern
Time
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Semi-Strong Form Efficiency

• Security prices reflect all publicly available
  information.
• Encompasses weak form efficiency
• Publicly available information includes
• Historical price and volume information
• Published accounting statements
• Information found in the WSJ

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Disbelievers

• Fundamental Analysts
• Use revenues, earnings, future growth forecasts,
  return on equity, profit margins, and other data
  to determine a company's underlying value and
  potential for future growth (Financial
  Statements)
• These guys make more sense than technical
  analysts. Why?

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Strong Form Efficiency

• Strong form efficiency says that anything
  pertinent to the stock price and known to at
  least one investor is already incorporated in the
  securitys price.
• Public Private
• Implies Insider trading will not earn excess
  return
• Strong form efficiency incorporates weak and
  semi-strong form efficiency.

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Disbelievers

• Pretty much everyone
• Insiders trading is generally profitable
• Galleon
• Raj Rajaratnam
• Martha Stewart

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What EMH Does and Does NOT Say

• Investors can throw darts to select stocks.
• Kind of We still need to consider risk
• Prices are random or uncaused.
• Prices reflect information.
• Price CHANGES are driven by new information,
  which by definition is random

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Implications of Efficient Markets

• Purchase or sale of any security can never be a
  positive NPV transaction.
• Trust market prices
• Stocks with similar risk are substitutes
• Mutual fund managers cannot systematically
  outperform the market

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The Evidence

• The record on the EMH is extensive, and generally
  supportive of the market being semi-strong form
  efficient

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Event Studies

• Event Studies examine returns around information
  release dates
• EX Earnings, Dividend announcements
• A test of semi-strong form efficiency
• Look at how quickly prices adjust to the
  information
• Looking for under-reaction, over-reaction, early
  reaction, or delayed reaction around the event.

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Event Study Results

• The studies generally support the view that the
  market is semi-strong form efficient.
• Studies suggest that markets may even have some
  foresight into the future, i.e., news tends to
  leak out in advance of public announcements.

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Event Studies Dividend Omissions
Efficient market response to bad news
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The Record of Mutual Funds

• If the market is semi-strong form efficient, then
  mutual fund managers, should not be able to
  consistently beat the average market return
• When we compare the record of mutual fund
  performance to a market index, we see that mutual
  funds are not able to CONSISTENTLY beat the
  market.
• Consistent with the market being semi-strong form
  efficient

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Mutual Fund Performance
Taken from Lubos Pastor and Robert F. Stambaugh,
Mutual Fund Performance and Seemingly Unrelated
Assets, Journal of Financial Exonomics, 63
(2002).
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Insider trading

• Strong form market efficiency implies that even
  insiders trading on private information cannot
  earn excess return
• A number of studies find that insiders are able
  to earn abnormal profits
• Violation of Strong form efficiency

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Verdict on Market Efficiency

• Market is pretty efficient
• Opportunities for easy profits are rare.
• Financial managers should assume, at least as a
  starting point, that security prices are fair and
  that it is difficult to outguess the market.
• New information is rapidly incorporated into the
  prices.

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EMH Exercises

• Indicate whether or not the EMH is contradicted,
  if so which form of EMH is contradicted
• An investor consistently earn an abnormal return
  over that expected by the market by examining
  charts of historical prices
• The acquisition of the latest annual report of a
  company enables an investor to earn an abnormal
  return.
• A stock which has been fluctuating between 25
  and 27 in the last three months suddenly rises
  to 40 per share right after management announces
  a new project that has a promising impact on the
  firm's expected future cash inflows.
• By subscribing to the Value Line Investment
  Survey, an investor can earn at least 5 over
  that earned by the market on comparable risk
  investments.

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EMH Exercises

• An investor consistently earn an abnormal return
  over that expected by the market by examining
  charts of historical prices
• Yes, Weak
• The acquisition of the latest annual report of a
  company enables an investor to earn an abnormal
  return.
• Yes, Semi-Strong
• A stock which has been fluctuating between 25
  and 27 in the last three months suddenly rises
  to 40 per share right after management announces
  a new project that has a promising impact on the
  firm's expected future cash inflows.
• No
• By subscribing to the Value Line Investment
  Survey, an investor can earn at least 5 over
  that earned by the market on comparable risk
  investments.
• Yes, Semi-Strong

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Why We Care

• Offering several points of view on how the market
  works, and the evidence for and against
• Using this you can form your own opinion about
  how the market works and invest accordingly