1. Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 10-1 Chapter 10

2. Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 10-2 Chapter Summary  Objective: To discuss the empirical evidence in support of equilibrium models. Tests of the Single Factor Model Tests of the Multifactor Model Other Studies

3. Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 10-3 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. Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 10-4 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. Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 10-5 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. Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 10-6 Single Factor Test Results Return % Beta Predicted Actual

7. Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 10-7 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

8. Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 10-8 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. Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 10-9 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. Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 10-10 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. Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 10-11 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

12. Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 10-12 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

13. Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 10-13 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. Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 10-14 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. Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 10-15 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

16. Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 10-16 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

17. Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 10-17 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

18. Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 10-18 Stochastic Volatility  Stock prices change primarily in reaction to information  New information arrival is time varying  Volatility is therefore not constant through time

19. Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 10-19 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

20. Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 10-20 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