Empirical Evidence on Security Returns

1
Chapter 10
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
• The Fama-French Three-Factor Model
• 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

6
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
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.

10
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.

11
Summary Reminder

• 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

12
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

13
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

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
• The Fama-French Three-Factor Model
• Other Studies

15
The Fama-French Three-Factor Model

• Size and book-to-market ratios, together with the
  market index, are systematic factors that explain
  returns on securities
• This has become known as the Fama-French
  Three-Factor Model
• Thus, size and book-to-market may be proxies for
  sources of systematic risk not captured by beta

16
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

17
Interpretations of Fama-French Models

• Size and book-to-market are factors that describe
  returns
• Results are consistent with APT
• Results may indicate irrational preferences for
  large size and low book to market firms
• More study needed

18
Interpretations of Fama-French Models

• Size and book-to-market are factors that describe
  returns
• Results are consistent with APT
• Results may indicate irrational preferences for
  large size and low book to market firms
• More study needed

19
Summary Reminder

• 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

20
Stochastic Volatility

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

21
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
• ARCH and GARCH Models incorporate time varying
  volatility

22
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