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In the first trading day after the break, the stock s return will accumulate all idiosyncratic noise over the non-traded period
Adjusted Beta =
2 1 HistoricBeta + 1 3 3
Betas will be biased! Dimson (1979): regression including lead and lag values of the market index Rj,t = j + l=-l1:l2j,lRM,t+l + j,t
True beta is a sum of all lead-lag betas: l=-l1:l2j,l
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Endogeneity problem
In the extreme, when the index is dominated by one stock, this stock will have beta of 1 by construction In Russia, this is a problem for Gazprom, Lukoil,
CAPM predictions
should be zero.
If not, there may be missing factors.
CAPM
The evidence
is the only relevant factor Relation between and returns is linear Over long periods the return on the market is greater than the risk free return
In general, riskier stocks should earn higher return on average
Market portfolio is mean-variance efficient If you cross-sectionally regress on risk premia, estimates should equal the average market risk premium ()
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2011 Patrick J. Kelly 102
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We observe the series of returns of the asset and of the market index We estimate beta (in-sample) and check whether other variables (const, D/P, P/E, B/M, ) explain remaining time variation in the asset s return
Cochrane (2001, Chapters 2 and 5) shows that any expected return can be related to any mean-variance efficient portfolio lying on the efficient frontier:
Data: US, 1926-1982, monthly returns of 11 industry portfolios and VW-CRSP market index For each individual portfolio, standard CAPM is not rejected But the joint test rejects CAPM
Data: US, 1965-1994, monthly returns of 10 size portfolios, VWCRSP market index Joint test rejects CAPM, esp. in the earlier part of the sample period
We check whether observed betas are (linearly) related to stock returns (as in the Security Market Line)
Did not reject CAPM But: betas are unstable over time
Testing CAPM
Results
E ( ri ) ! rf = ! + "i,mv " E ( r mv ) ! rf $ # %
E ( ri ) = rf + !i,mv " E ( r mv ) ! rf $ # %
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0.56 0.94 1.02 0.98 1.11 1.14 0.59 0.76 1.08 0.76 1.42
of the the a June year, The preME-7 ME-4 ME-8 ME-5 ME-2 All ME-9 ME-6 ME-3 decile The The The returns of average is and Portfolios Small-ME Large-ME Alllargest with current calculated (as average portfolio year 7 forrequirementsare ME t average equal-weighted is and to Size number (t size July subdivided the Average column of return post-ranking = 0.95 1.07 1.29 1.24 1.52 All 0.89 1.10 1.17 1.25 1.29 1.25 post-ranking CRSP-COMPUSTAT is prior of and available) formed fls number into deciles portfolios the Os stocks establish shows of year 10 data of is for denominateduse t yearly. then month's the f (here in time-seriestheto 3 ending 1963-1990) Returns, the ,: 1.01 1.09 1.08 1.27 1.25 1.34 stocks 0.98 0.95 1.34 1.12 1.71 Low-f the in The full and between statistics per time-seriesJune stocks size-fmillionsreturns of June using averagein 11 portfolios requirements for on all (July all Stocks fl-2 in of of of 0.93 1.05 1.53 1.13 1.42 1.29Panel 0.88 1.21 1.42 1.31 1.57 and month breakpoints. are the average year using breakpoints t A: each 22. for 1963 other year NYSE + : portfolios of forJuly dollars. t. monthly to 1. The Post-Ranking fl-3 the in the Sorted 1.02 1.26 1.39 1.17 1.79 1.10 1.37 1.27 1.54 1.36 1.36 the tables) We allocated onO3s Average group. size 1963 stocks equal-weighted size-: to pre-ranking on size to are use averages December monthly value-weighted ,Bsthe and fl-4 ME 1.14 1.09 1.48 1.70 1.61 0.94 1.20 1.15 1.06 1.39 1.31 the Table deciles of (ME, Monthly of only I equal-weighted 10 CRSP. 2 1990) portfolios sum size-decile portfolio All and size price f-5 ln(ME) of 1.07 1.18 1.42 1.29 1.50 0.93 1.27 1.20 1.34 1.65 1.33 3 in (Down) NYSE of Returns Average December for monthly the sample individual (ME)is the times (in equal-weighted of NYSE, then stocks f-6 NYSE, 1990 Size portfolios 0.89 0.98 1.21 1.06 1.61 1.28 1.23 1.11 1.18 1.10 1.50 stocks slopes returns stocks, shares betweenin smallest that AMEX, For Percent) portfolios. portfolio 15 from on using the AMEX, size a fl-7 the 1.03 1.18 1.18 1.41 1.37 1.24 0.94 1.24 1.13 1.31 1.37 meet post-ranking theand The and and estimated 41,decile returns, the All portfolio outstanding) in Pre-Ranking NYSE fl-8 and at (afterreturns with 0.71 1.02 1.04 1.17 1.31 1.21 0.82 0.62 1.27 1.36 1.63 ( Portfolios resulting regression 2 NASDAQ row varies the of for 100 to the deciles 1972) 5 percent. end fl-9 are stocks each shows from 0.74 1.01 1.07 1.35 1.34 1.25 0.88 1.32 1.18 1.26 1.50 70 averageof The monthly years breakpoints. Formed (Across): to portfolios that of June on NASDAQ CRSP-COMPUSTAT are portfolio. Each 177. of statistics meet number average returns determined the data size in for forThe each stocks. then monthly size on The
There are no systematic deviations from the return predicted by the CAPM
Run CAPM regressions using 342 months of data for 25 size and book-to-market portfolios
Run time series regression for N assets: Ri,t-RF = i + i(RM,t-RF) + i,t (+ iXi,t-1) Usually, N portfolios
Fama-French (1993)
High-fl
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Cross-sectional tests
Main idea: Ri,t = 0 + 1i + i,t (+2Xi,t) H0: asset returns lie on the SML
Where f is a return based factor or portfolio return on the meanvariance efficient frontier, ET(f) is the sample mean of the factor, and (f) the sample standard deviation, T is the number of observations, N is the number of test assets, 1 is the number of factors, is a vector of the intercepts from the N test-asset regressions, and is the cross test asset residual covariance matrix, such that E !t!t! = "
The intercept is the risk-free rate: 0 = RF The slope is the market risk premium: 1 = mean(RM-RF) > 0 There are no additional effects: 2 = 0 We first need to estimate them measurement error Usually, use predicted betas (estimated over the previous period)
The realized returns may be very different from the expected returns (in SML)
We need to estimate this cross-sectional regression over many periods (to measure average effect)
Mean of
2011 Patrick J. Kelly 109
Two-stage procedure
Recursive procedure: for each t (e.g., every month), repeat
Time-series regression over the previous K periods to estimate beta
Results
Fama-MacBeth (1973): estimate CS regression Ri,t-RF = 0 + 1i + 22i + 32,i + i,t
1 > 0: positive effect of beta 2 = 0: no non-linear effects of beta 3 = 0: no impact of idiosyncratic risk
Cochrane (2001)
Sort all NYSE stocks into 10 size deciles, add government and corporate bonds Run separate time-series regressions to estimate 12 portfolio betas Regress sample average portfolio returns against estimated betas Compare fitted SML with the one predicted by the CAPM
CAPM does well in explaining stock vs. bond returns, but poorly in explaining large vs. small-cap stocks
Monthly cross-sectional regressions to test if high beta is associated with high return
Cochrane (1999) shows that GMM panel regressions are identical under some assumptions
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Average Slopes (t-Statistics) from Month-by-Month Regressions of Stock Returns on ,B,Size, Book-to-Market Equity, Leverage, and E/P: July 1963 to December 1990
If returns are linear in Beta, all that proves is that the market is ex-post efficient
If they are not linear in beta you do not know if it is because the market is
ex-post inefficient or because there is a missing factor
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or is it ICAPM?
In the US: Unexpected Inflation Term structure (Long government bonds short) Default premium (High risk corporate bonds long government bonds) Growth in Industrial production Consumption Growth Oil prices
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More recent work provides evidence of both market-wide and exchange-specific factors [Goyal, Perignon, and Villa (2008)]
In US 2 factors common to all stock, plus unique (separate) factors of NASDAQ and NYSE.
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2011 Patrick J. Kelly
Average Monthly Returns on Portfolios Formed on Size and Book-to-Market Equity; Stocks Sorted by ME (Down) and then BE/ME (Across): July 1963 to December 1990
In June of each year t, the NYSE, AMEX, and NASDAQ stocks that meet the CRSPCOMPUSTAT data requirements are allocated to 10 size portfolios using the NYSE size (ME) breakpoints. The NYSE, AMEX, and NASDAQ stocks in each size decile are then sorted into 10 BE/ME portfolios using the book-to-market ratios for year t - 1. BE/ME is the book value of common equity plus balance-sheet deferred taxes for fiscal year t - 1, over market equity for December of year t - 1. The equal-weighted monthly portfolio returns are then calculated for July of year t to June of year t + 1. Average monthly return is the time-series average of the monthly equal-weighted portfolio returns (in percent). The All column shows average returns for equal-weighted size decile portfolios. The All row shows average returns for equal-weighted portfolios of the stocks in each BE/ME group.
Book-to-Market Portfolios All All Small-ME ME-2 ME-3 ME-4 ME-5 ME-6 ME-7 ME-8 ME-9 Large-ME 1.23 1.47 1.22 1.22 1.19 1.24 1.15 1.07 1.08 0.95 0.89 Low 0.64 0.70 0.43 0.56 0.39 0.88 0.70 0.95 0.66 0.44 0.93 2 0.98 1.14 1.05 0.88 0.72 0.65 0.98 1.00 1.13 0.89 0.88 3 1.06 1.20 0.96 1.23 1.06 1.08 1.14 0.99 0.91 0.92 0.84 4 1.17 1.43 1.19 0.95 1.36 1.47 1.23 0.83 0.95 1.00 0.71 5 1.24 1.56 1.33 1.36 1.13 1.13 0.94 0.99 0.99 1.05 0.79 6 1.26 1.51 1.19 1.30 1.21 1.43 1.27 1.13 1.01 0.93 0.83 7 1.39 1.70 1.58 1.30 1.34 1.44 1.19 0.99 1.15 0.82 0.81 8 1.40 1.71 1.28 1.40 1.59 1.26 1.19 1.16 1.05 1.11 0.96 9 1.50 1.82 1.43 1.54 1.51 1.52 1.24 1.10 1.29 1.04 0.97 High 1.63 1.92 1.79 1.60 1.47 1.49 1.50 1.47 1.55 1.22 1.18
controlling for size, book-to-market equity captures strong variation in average returns, and controlling for book-to-market equity leaves a size effect in returns. averageKelly 2011 Patrick J. 125 B. The Interaction between Size and Book-to-Market Equity The average of the monthly correlations between the cross-sections of ln(ME) and ln(BE/ME) for individual stocks is - 0.26. The negative correlation is also apparent in the average values of ln(ME) and ln(BE/ME) for the portfolios sorted on ME or BE/ME in Tables II and IV. Thus, firms with low market equity are more likely to have poor prospects, resulting in low stock prices and high book-to-market equity. Conversely, large stocks are more likely to be firms with stronger prospects, higher stock prices, lower book-tomarket equity, and lower average stock returns. The correlation between size and book-to-market equity affects the regressions in Table III. Including ln(BE/ME) moves the average slope on ln(ME) from -0.15 (t = -2.58) in the univariate regressions to -0.11 (t = -1.99) in the bivariate regressions. Similarly, including ln(ME) in the regressions
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(iii)
S I l l; L l l
X(r) -
2 3
RF(I) = u + sSMtqr) + hlfML&) + t(r) Book-to-market equity (HE/ME) quintiles I.92 0.53 0.55 0.97 0.58 0.64 2.00 2.40 0.60 0.66 2.00 2.58 0.62 0.79 2.78 1.55 Low 2 4 High 0.51 0.44 3.41 2.23 - RF(r)] + OI~ERM(I) 0.00 0.92 0.02 0.93 0.05 0.89 0.13 0.96 0.16 0.53
~~
- 0.34 0.31 -0.11 0.35 - 0.1 I 0.34 0.09 0.4 1 0.21 0.34
- 0.12 0.62 - 0.01 0.63 0.04 0.58 - 0.22 0.27 - 0.05 0.30 (v) H(l) - 0. I3 0.15 - 0.02 0.17 0.04 - 0.1s 0.22 -- 0.14 0.05 - 0.07
- 0.05 0.71 0.08 0.77 - 0.04 0.60 - 0.08 0.4) -0.13 0.25
K(r) (i) W(r) = 0 + h[RM(r) + K(r) - W(r) = (I 0.01 0.80 0.03 0.75 0.05 0.73 0.03 0.69 - 0.05 0.50
sSM&I) h/IML(f) + V(I) + dDEF(f)+ + t$r) - 1.47 - 0.73 - 3.16 2.20 0.75 1.73 1.04 - 1.24 - 0.20 2.60 0.93 I.91 - 1.42 0.47 - 0.47 2.28 I.00 I .9Y I .07 - 2.65 - 0.99 1.96 1.34 1.01 3.27 - 1.46 - 0.67 1.17 1.35 1.27 + dDEF(r) + &) - 0.79 1.54 1.10 - 2.35 0.42 1.n2 - 0.94 - 1.20 1.46 - 0.70
0.22 2.61 0.51 2.85 0.7 I 3.01 0.33 2.X8 0.69 2.36
0.14 2.87 0.34 3.03 0.56 3.1 I I .24 3.35 - I.41 2.14
--
~~_.___ - 0.04
RF(f) = u + h[RM(r) - RF(r)] + sSMB(r) + hHML(r) + ntTERM(r) (ii) R(r) - RF(r) = u + ~[RM(I) - RF(r)] + ($0 0.0 I 0.00 - 1.58 - 0.05 - 3.24 - O.YO 0.42 0.54 0.30 0.73 0.0x 0.04 0.02 - 0.24 ~ 1.29 - 1.00 0.3) I .05 0.53 - 0.36 0.03 0.06 0.05 - 1.45 0.48 - 1.12 0.39 0.23 1.25 0.50I 3 - 0.08 0.04 0. 1.04 - 2.67 - 0.50 - 1.50 0.35 0.57 0.12 3.29 - 0.72 - 0.13 - 0.06 - 0.17 - 0.4Y - 0.95 0.20 0.21 _ ~~~~__.~~~.~. - 0.07 ~~~
0.20 2.19 0.67 2.7Y 0.79 3.20 0.47 2.91 0.73 1.89
0.09 2.53 0.29 3.01 0.56 3.19 1.23 - 3.71 I.51 1.41
See footnote