This chapter discusses empirical tests of equilibrium models like the Capital Asset Pricing Model (CAPM) and the multifactor model. It summarizes studies that test the single-factor CAPM and find it does not fully validate the expected return-beta relationship. Multifactor models that include factors like industrial production and bond risk premiums explain returns better. However, later studies by Fama-French found firm size and book-to-market ratios better explain returns than beta. Subsequent research further examined these issues and the time-varying nature of volatility.
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1. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Chapter 10
Empirical Evidence
on Security Returns
2. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
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 Ryan INVESTMENTS, Fourth Canadian Edition
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 Ryan INVESTMENTS, Fourth Canadian Edition
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 Ryan INVESTMENTS, Fourth Canadian Edition
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 Ryan INVESTMENTS, Fourth Canadian Edition
Single Factor Test
Results
Return %
Beta
Predicted
Actual
7. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
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 Ryan INVESTMENTS, Fourth Canadian Edition
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 Ryan INVESTMENTS, Fourth Canadian Edition
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 Ryan INVESTMENTS, Fourth Canadian Edition
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 Ryan INVESTMENTS, Fourth Canadian Edition
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 Ryan INVESTMENTS, Fourth Canadian Edition
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 Ryan INVESTMENTS, Fourth Canadian Edition
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 Ryan INVESTMENTS, Fourth Canadian Edition
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 Ryan INVESTMENTS, Fourth Canadian Edition
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 Ryan INVESTMENTS, Fourth Canadian Edition
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 Ryan INVESTMENTS, Fourth Canadian Edition
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 Ryan INVESTMENTS, Fourth Canadian Edition
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 Ryan INVESTMENTS, Fourth Canadian Edition
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 Ryan INVESTMENTS, Fourth Canadian Edition
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