Lecture 1 - Nov. 3, 2011

11/3/2011
1
Empirics of Financial Markets Empirics of Financial Markets
Patrick J. Kelly, Ph.D.
MICEX
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MICEX returns
WHY?
MICEX + constituents: levels
MICEX + constituents: returns
11/3/2011
2
Asset Pricing Models in General
Asset pricing models relate expected stock returns to
factors. Typically, these are written as linear models
(because easier than non-linear):
These linear models are an approximation of marginal
utility growth.
This says: Discounted aggregate marginal utility growth
approximately follows some function of factors (f)
What Are Factors?
These factors are proxies for marginal utility growth:
Factors signal current (or forecast future) marginal
utility growth.
What grows or stunts marginal utility?
States of the economy: consider when the economy goes bad, put
extra value on assets/portfolios with high payoffs in these bad states
Such portfolios will have high prices and low returns
In some models factors can be those that forecast future
marginal utility growth, but they shouldnt predict too well
(otherwise the models will predict larger than factual interest variation)
This is why we use changes, not levels: returns, not prices
Asset Pricing Models:
Different ways to model marginal utility growth
Capital Asset Pricing Model (CAPM)
One factor
Intertemporal CAPM (ICAPM)
CAPM + 1 factor to capture changes in investment
opportunities
Arbitrage Pricing Theory (APT)
Multi-factor
CAPM
r
w
is the return to current wealth NOT just the
market. Includes:
Labor income
Real estate
Any private property
All public property (parks, lakes, roads, bridges)
One period model (ignores time)
The foundations of CAPM
Sharpe, Lintner and Treynor (separately) grounded
asset pricing in a single market factor
Because they created models of asset prices that built on the
intuition in Markowitzs portfolio theory, which
simply notes that
Investors do not (should not?) care about any one asset in their
portfolio of assets, but they should only care about the risk and
reward of the entire portfolio.
and demonstrates
The power of diversification across many assets
This class
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3
Goal of Course
Briefly introduce key theories in finance
Mostly related to
Asset pricing
Market efficiency
Learn the empirical tests of these theories Learn the empirical tests of these theories
And what the data tell us about the theories
What we will cover
Portfolio theory
With liquidity and short sale constraints
Asset Pricing
Market Efficiency Market Efficiency
Event studies
Return predictability
At long and short horizons
Behavioral Finance
Syllabus
40% of class 3 projects
Find one partner
E-mail me if you have problems pkelly@nes.ru
I expect you know Gauss and Excel
If you dont, rethink taking this class
60% of grade final exam
In English
You will have at least one sample exam
Few surprises
Please pay attention to my.nes.ru!
Portfolio Selection
Whats next?
We are going to run through about 1/4
th
to 1/3
rd
the
material I cover in a typical MBA Investments and
Portfolio Management class
in about 45 min to an hour.
The point:
To give you some of the basic intuition before you start
applying the reasoning to the data in your assignments
Portfolio Selection
Marokowitz (1952)
Prior belief: investors should solely maximize the discounted
value of cash flows
Two assets with the same discounted cash flows are equally good
regardless of risk
Proposes/Assumes the Mean-Variance Criterion
Investors care about both risk and return
Shows that through diversification investors can get a
maximum return for a minimum of risk
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4
Mean-Variance Criterion
Investors prefer more to less and dislike risk
From this, we can build a theory of investment choice based
on the expected (mean) return of an investment (higher =
better) and its risk as measured by the variance of returns
(lower = better)
This is the mean-variance criterion.
Critical assumption: the variance of returns is a good characterization
2008 Patrick J. Kelly 19 2008 Patrick J. Kelly 19
Critical assumption: the variance of returns is a good characterization
of the investment risk that investors care about
rr
s.d. s.d.
Mean Variance Criterion provides
Intuitive assessment of the relative merits of assets and
portfolios of assets
Mean variance space is spanned by only two funds
(portfolios).
A i k f d ffi i i k f li A risk free and an efficient risky portfolio
Translates directly to investor Utility as a function of
portfolio return and variance
We can show our preferences (Utility)
E[r]
Q
S
Higher
Return
2
2
1
] [ o A r E U =
Indifference
Curve
P
R
More
Risk
Critical Assumption
Variance (Standard Deviation) is only characteristic of
risk important to us
For example Skewness doesnt matter
Normal Distribution
rr
Symmetric distribution Symmetric distribution
s.d. s.d.
Skewed Distribution: Large Negative Returns Possible
rr
Negative Negative Positive Positive
Median
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5
Skewed Distribution: Large Positive Returns Possible
rr Negative Negative Positive Positive
Median
We will assume returns follow a Normal Distribution
rr
s.d. s.d.
M52: Investors care about the risk and return of their portfolio (of Many
Risky Assets)
For a portfolio of N risky securities, variance is:
The first term sums N variances; the second term
o
p
2
= w
i
2
var( i) + w
i
w
j
cov( i, j)
j =1
i = j
N
i =1
N
i =1
N

;
captures Nx(N-1) covariances.
Diversification does not eliminate all risk.
Several Stocks
Yearly Returns for 5 Stocks
40.00%
60.00%
80.00%
100.00%
120.00%
GE
S.Cal.Edison
-60.00%
-40.00%
-20.00%
0.00%
20.00%
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
Return
Y
e
a
r
McGrawHill
ConAgra
CitiGroup
Portfolio of Several Stocks
Yearly Returns for 5 Stocks
40.00%
60.00%
80.00%
100.00%
120.00%
GE
S.Cal.Edison
-60.00%
-40.00%
-20.00%
0.00%
20.00%
1
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Return
Y
e
a
r
McGrawHill
ConAgra
CitiGroup
Returns and Standard Deviations
GE S.Cal.Edison McGrawHill ConAgra CitiGroup eqAvg
Mean 16.60% 8.11% 13.34% 12.97% 22.34% 16.17%
SD 26.27% 28.34% 18.89% 22.49% 37.72% 19.53%
r
f
=4%
Reward-to-
risk 0.4796 0.1450 0.4944 0.3988 0.4862 0.6223
11/3/2011
6
Possible to split investment funds between safe and
risky assets
Risk free asset: proxy; T-bills
Risky asset: stock (or a portfolio)
Controlling Risk: Allocating Between Risky & Risk-Free Assets
Ultimately we will see that under some assumptions
a risk-free asset and a particular risky portfolio span
the mean-variance return space.
Entire Stock Market vs. T-Bills
Entire Market Return vs. T-Bill Rates
10.00%
20.00%
30.00%
40.00%
50.00%
-40.00%
-30.00%
-20.00%
-10.00%
0.00%
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20
00
20
02
T-Bill Rate Entire Market
r
f
= 7% r
f
= 7%
o
rf
= 0% o
rf
= 0%
E[r
a
] = 15% E[r
a
] = 15% o
a
= 22% o
a
= 22%
Example
aa
w = % in a w = % in a (1-w) = % in r
f
(1-w) = % in r
f
E[r
p
] = wE[r
a
] + (1 - w)r
f
E[r
p
] = wE[r
a
] + (1 - w)r
f
r
p
= combined portfolio r
p
= combined portfolio
For example, w = .75 For example, w = .75
Expected Returns for Combinations
E[r
p
] = .75(.15) + .25(.07) = .13 or 13% E[r
p
] = .75(.15) + .25(.07) = .13 or 13%
o
p
= .75(.22) + .25(0) = .165 or 16.5% o
p
= .75(.22) + .25(0) = .165 or 16.5%
What Return for What Risk?
E[r] E[r]
E[r E[r
aa
] = 15% ] = 15%
aa
CAL CAL
(Capital (Capital
Allocation Allocation
Line) Line)
rr
ff
= 7% = 7%
22% 22%
00
ff
) S = 8/22 ) S = 8/22
E[r E[r
aa
] ] - - rr
ff
= 8% = 8%
o
E[r E[r
pp
] = 13% ] = 13%
16.5% 16.5%
Extending the CAL
E(r)
E(r E(r
pp
) = 15% ) = 15%
aa
rr
ff
= 7% = 7%
22% 22%
00
FF
) S = 8/22 ) S = 8/22
E(r E(r
pp
) ) - - rr
ff
= 8% = 8%
o
11/3/2011
7
The Capital Allocation Line
CAL depicts the possible asset allocations, i.e. risk-
return combinations
Slope S of CAL =
Measures the increase in expected return an investor obtains
f t ki dditi l it f t d d d i ti i k
( )
( )
364 . 0
22
8
22
7 15
= =
=
P
F P
r
r r E
S
o
for taking on one additional unit of standard deviation risk
Also called the
reward-to-variability ratio
Sharpe Ratio
Extending the CAL
The portfolio has the most risk if all monies are
invested in a (w=1)
Q: How can we assume even more risk?
A: Since risk increases linearly in w, we need to increase
w > 1 (borrow money to invest in a)
B i h i k f i il bl f
Borrowing at the risk-free rate is not available for
individual investors, need to borrow at a rate r
B
> r
F
CAL with Borrowing
E(r)
E(r E(r
pp
) = 15% ) = 15%
aa
rr
ff
= 7% = 7%
22% 22%
00
FF
) S = 8/22 ) S = 8/22
E(r E(r
pp
) ) - - rr
ff
= 8% = 8%
o
Is there an optimal portfolio choice?
E(r) E(r)
E(r E(r
pp
) = 15% ) = 15%
aa
CAL CAL
(Capital (Capital
Line) Line)
rr
ff
= 7% = 7%
22% 22%
00
FF
) S = 8/22 ) S = 8/22
E(r E(r
pp
) ) - - rr
ff
= 8% = 8%
o
Portfolio Example
Consider an example where we can invest into risky
assets (stocks, funds) 1 and 2.
Asset 1: E(r
1
) = 10%
1
= 12%
Asset 2: E(r
2
) = 17%
2
= 25%
What is the expected portfolio return and standard
deviation?
Benefits from Diversification
| | | | | |
2 2 1 1
r E w r E w r E
p
+ =
2 , 1 2 1 2 1
2
2
2
2
2
1
2
1
2 w w o o o o o w w
p
+ + =
Asset 1: E(r
1
) = 10%
1
= 12%
Asset 2: E(r
2
) = 17%
2
= 25%
Portfolio Standard Deviation (%) for Given Correlation
Weight in 1 E(r) portf. 1,2 = - 1 1,2 = 0 1,2 = 0.2 1,2 = 0.5 1,2 = 1
0
0.2
0.4
0.6
0.8
1
Portfolio Standard Deviation (%) for Given Correlation
Weight in 1 E(r) portf. 1,2 = - 1 1,2 = 0 1,2 = 0.2 1,2 = 0.5 1,2 = 1
0 17.0 25.0 25.0 25.0 25.0 25.0
0.2 15.6 17.6 20.1 20.6 21.3 22.4
0.4 14.2 10.2 15.7 16.6 17.9 19.8
0.6 12.8 2.8 12.3 13.4 15.0 17.2
0.8 11.4 4.6 10.8 11.7 12.9 14.6
1 10.0 12.0 12.0 12.0 12.0 12.0
The lower the correlation the
lower the portfolio variance
Even though the
expected return
is the same
11/3/2011
8
How does risk reduction depend on ?
Asset 1: E(r
1
) = 10%
1
= 12%
Asset 2: E(r
2
) = 17%
2
= 25%
Portfolios of More the Two Risky Assets
We are looking for the lowest variance portfolio for a
given return
MIN o
p
2
= w
i
2
var(r
i
) + w
i
w
j
cov(r
i
, r
j
)
j=1
i=j
N
i=1
N
i=1
N

j
subject to : E[r
p
] = a given return
and w
i
i=1
N
=1
Portfolios of More the Two Risky Assets
We are looking for the lowest variance portfolio for a
given return
2
1

2
E ' = o w w MIN
p

1 and
:
= '
= '
i

w
E w to subject

0 and > w
with short-sale constraints

Efficient Trade-off Line & Efficent Frontier Curve
15%
20%
25%
R
e
t
u
r
n
What Happens When We Add More Assets?
15%
20%
25%
R
e
t
u
r
n
B
2
0%
5%
10%
0% 5% 10% 15% 20% 25% 30%
Standard Deviation
E
x
p
e
c
t
e
d

0%
5%
10%
0% 5% 10% 15% 20% 25% 30%
Standard Deviation
E
x
p
e
c
t
e
d

R
A
1
15%
20%
25%
R
e
t
u
r
n
There is a unique optimal portfolio
MMarket
0%
5%
10%
0% 5% 10% 15% 20% 25% 30%
Standard Deviation
E
x
p
e
c
t
e
d

R
15%
20%
25%
R
e
t
u
r
n
There is a unique optimal portfolio
MMarket
Systematic/Covariance Risk Idiosyncratic Risk (n
i
)
0%
5%
10%
0% 5% 10% 15% 20% 25% 30%
Standard Deviation
E
x
p
e
c
t
e
d

R
11/3/2011
9
How can we tell?
How can we tell if adding more assets improves the
efficient frontier?
Mathematically adding any less than perfectly correlated
security ought to improve the ex-ante efficient frontier
Improvement may not be meaningful
The problem is that the ex-ante efficient frontier will
always lie within the ex-post efficient frontier.
Simply due to luck? consider
Testing Portfolio Efficiency
Consider the question whether a certain portfolio 1 is
still efficient if one makes available additional assets (2,
3 and 4)
If Expected returns and covariances were known, then easy
If you cannot form a portfolio with higher mean and/or lower
variance by including assets 2, 3, and 4 then 1 still efficient
Problem:
With a probably of 1, the true ex-ante efficient portfolio is
within the empirically observed efficient portfolio.
To illustrate the problem, consider.
Illustration (Sentana, 2009)
Suppose assets/funds 1, 2, 3 and 4 all have E[r-r
f
]=0
and Cov(i,j) =0 for all
In truth, adding assets 2, 3 and 4 will not improve the
reward for risk and will not change the efficient
tf li portfolio.
The next chart simulates two years of daily returns and
plots the efficient frontiers from these simulations
where the TRUE ex-ante Sharpe ratio is ZERO.
Simulated Efficient Frontiers (Sentana, 2009)
Sampling Distribution of the GMM estimator
true
Mean of
Simulated
The point
The sampling error is large when using sample means,
variances and covariances to estimate expected means
and variances, but
Statistical tests are well suited to the problem
11/3/2011
10
Intuition: Tests of Mean Variance Efficiency
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:
E r
i
( )
= r
f
+ |
i,mv
E r
mv
( )
r
f
This structure suggests a natural test for efficiency:

Test whether is non-zero.
This is the basic intuition of most tests of portfolio efficiency
Differences across tests are mostly econometric refinements
E r
i
( )
r
f
=o + |
i,mv
E r
mv
( )
r
f
Test of Mean Variance Efficiency

Gibbons, Ross, Shenken (1989)
T N 1
N
1+
E
T
f
( )
o f
( )
|
\
|
.
|
|
2
(
(
1
' o
E
1
o ~ F
N,TN1
Where f is a return based factor or portfolio return on the
mean-variance efficient frontier, E
T
(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 c
t
' c
t
| |
= E
Mean of
Refinements
The GRS test is reasonably robust to small departures
from normality of the return distribution
MacKinlay and Richardson (1991, Journal of Finance)
propose refinements to deal with leptokurtosis in
returns in a GMM framework.
Hodgson, Linton, and Vorkink (2002, Journal of Applied
Econometrics) derive semi-parametric tests that posses
more power to reject the null.
See Sentana (2009, Econometrics Journal) for a discussion
of further refinements
Testing whether a portfolio is mean-variance efficient
Useful for:
Mutual Fund performance evaluation
Measuring gains from portfolio diversification
Tests of linear asset pricing models
Not trivial because:
Realized returns are not the same as expected returns
*Ideas borrowed from Sentana (2009)
Homework 1
Discussion of
Liquidity and its definitions
Finding the efficient frontier and the optimal portfolio g
@Risk and VaR analyses
Bootstrapping
A prelude p
11/3/2011
11
Last Time: a Steeper CAL is better
E(r) E(r)
E(r E(r
pp
) = 15% ) = 15%
aa
CAL CAL
(Capital (Capital
Line) Line)
rr
ff
= 7% = 7%
22% 22%
00
ff
o
S = 0.36 S = 0.36
S = 0.72 S = 0.72
Risk in Equally-Weighted Portfolios
Avg. Std. Dev. 30%
Avg. Correlation 0.2
# of Assets Portfolio Due to Due to
Std. Dev. Variances Covariances
Std. Dev. Variances Covariances
2 23.24% 83.33% 16.67%
3 20.49% 71.43% 28.57%
4 18.97% 62.50% 37.50%
100 13.68% 4.81% 95.19%
1000 13.44% 0.50% 99.50%
10000 13.42% 0.05% 99.95%
How Can We Raise the CAL?
Raise Return
( )
( )
P
F P
r
r r E
S
o

=
Lower risk
Diversify with Risky Assets
15%
20%
25%
R
e
t
u
r
n
What Happens When We Add More Assets?
15%
20%
25%
R
e
t
u
r
n
B
2
0%
5%
10%
0% 5% 10% 15% 20% 25% 30%
Standard Deviation
E
x
p
e
c
t
e
d

0%
5%
10%
0% 5% 10% 15% 20% 25% 30%
Standard Deviation
E
x
p
e
c
t
e
d

R
A
1
15%
20%
25%
R
e
t
u
r
n
Which portfolio does everyone choose?
MMarket
0%
5%
10%
0% 5% 10% 15% 20% 25% 30%
Standard Deviation
E
x
p
e
c
t
e
d

R
Optimal Decision Rule
If everyone prefers more return to more risk and everyone
sees the same assets there is only one best risky
portfolio. Meaning:
Optimal Portfolio Selection takes 2 steps:
1. Choose Optimal Risky Portfolio
2. Optimal Allocation between Risky and Riskless
This is called the Separation Property
Notice this means:
All rational risk-averse investors will passively index holdings
to some risky fund and account for risk aversion by keeping
some money totally safe
11/3/2011
12
Asset Pricing Implications
If everyone chooses the same portfolio (by the
separation property), how do we value an individual
stock?
Does its return matter?
Does its standard deviation matter?
Many Risky Assets
For a portfolio of N risky securities, variance is:
The first term sums N variances; the second term
o
p
2
= w
i
2
var( i) + w
i
w
j
cov( i, j)
j =1
i = j
N
i =1
N
i =1
N

;
captures Nx(N-1) covariances.
As N gets large, which of the two dominates?
The variances are overwhelmed.
Nx(N-1) gets much larger than N
What if... ?
If there were enough assets to diversify
away all firm-specific risk, would you want
to hold any?
Why?
Rational investors and diversified portfolio
If you are able to complete diversify away firm specific
risk, you will
Because no one will be willing to pay you anything for
taking that risk.
Capital Asset Pricing Model
William Sharpe & John Lintner (1964) insight was that
we should only care about how a stock comoves with
the rest of the market because the firm-specific
variance can be diversified away.
Assumptions of the CAPM
1. Perfect competition: Markets are large and investors are
price takers
2. Frictionless markets: no taxes and no transactions costs
3. Complete markets: All risky assets are publically traded
4. Unlimited borrowing and lending at the risk-free rate (or
unlimited shorting)
5. Homogenous expectations: Everyone sees the same
efficient frontier, because everyone holds the same
beliefs about expect returns and variances
6. Investors follow the mean-variance criterion and have an
identical one holding period over which the mean-
variance criterion is applied (utility is maximized)
11/3/2011
13
From Assumptions to CAPM
1. Raise the capital allocation line
Mean variance criterion
2. Maximum diversification
Frictionless markets
3. Investors choose the same optimal portfolio
Homogeneous expectations, perfect competition, complete
markets, and unlimited borrowing and lending at the risk-
free rate
4. Only systematic (market) risk is important
Only covariance risk matters
Only one price of risk
20%
25%
n
Capital Market Line (CML)
MMarket
CML
0%
5%
10%
15%
0% 5% 10% 15% 20% 25% 30%
Standard Deviation
E
x
p
e
c
t
e
d

R
e
t
u
r
MMarket
M
f M
r r E
o
) (
Measuring Systematic Risk
Could use cov(E[r
stock
], E[r
market
])
BUT:
again, the units are a pain with cov(). Correlation, then?
No; what is the correlation between 2 systematic risks?
Doesnt account for how much it moves when correlated
We need a measure of a stocks systematic risk only.
This is beta (|) which is unitless:
This is beta (|), which is unitless:
Why it isnt this:
Actually, numerically identical
) ] [ var(
) ] [ , ] [ cov(
f m
f m f i
i
r r E
r r E r r E

= |
]) [ var(
]) [ ], [ cov(
m
m i
i
r E
r E r E
= |
Reward for risk
Reward for no systematic risk (=0)
r
f
Reward for investing in the market portfolio (=1)
E[r
m
]-r
f
Reward for investing in any asset:
( )
f m i f i
r r E r r E = ] [ ] [ |
Asset Pricing Models in General
Asset pricing models relate expected stock returns to
factors. Typically, these are written as linear models
(because easier than non-linear):
These linear models are an approximation of marginal
utility growth.
This says: Discounted aggregate marginal utility growth
approximately follows some function of factors (f)
What Are Factors?
These factors are proxies for marginal utility growth:
Factors signal current (or forecast future) marginal
utility growth.
What grows or stunts marginal utility?
States of the economy: consider when the economy goes bad, put
extra value on assets/portfolios with high payoffs in these bad states
Such portfolios will have high prices and low returns
In some models factors can be those that forecast future
marginal utility growth, but they shouldnt predict too well
(otherwise the models will predict larger than factual interest variation)
This is why we use changes, not levels: returns, not prices
11/3/2011
14
Asset Pricing Models:
Different ways to model marginal utility growth
Capital Asset Pricing Model (CAPM)
One factor
Intertemporal CAPM (ICAPM)
CAPM + 1 factor to capture changes in investment
opportunities
Arbitrage Pricing Theory (APT)
Multi-factor
CAPM
r
w
is the return to current wealth NOT just the
market. Includes:
Labor income
Real estate
Any private property
All public property (parks, lakes, roads, bridges)
One period model (ignores time)
Mertons (1973) ICAPM
Multi-period version of CAPM
Factors are state variables that determine how well the
investor can do his/her optimization. A factor that can be
anything that affects
t lth current wealth
the distribution of distribution of future returns
Labor market income, Housing value, Small business
Changes in the investment opportunity set.
Investors with long horizons are unhappy with news that future returns
are lower
High value to assets which are negatively correlated with long term
wealth. That is, prefer stocks with high payouts during recessions
Anything that affects the average investor
Note about the extra ICAPM factor
The ICAPM state variable(s) should affect the average
investor.
Consider a risk that in the future makes A better off and B
worse off
B sells the risk
A buys it
Net effect is zero.
This helps explains why LOTS of variables are
correlated with returns, but do not carry any priced risk
For example: Industry returns comove, but not once you
control for priced risks.
APT
Using the Law of One Price
Common comovements of stock returns should have
the same price
Complete idiosyncratic price movements are not priced
If well diversified only common factors affect consumption
I t iti i th p i bit pl Intuition is the same as previous arbitrage example
No restrictive assumptions about returns or preferences
APT does not suggest factors. It says start statistical
Find comovement in stock returns
ICAPM says start with theory when looking for factors
Variables that affect the distribution of returns
Weaknesses of CAPM and ICAPM
CAPM is linear and does not price non-normally
distributed returns well
Should price derivatives, but generally cannot, their returns
are too non-normal
Why linear?
Identity of state variables (f ) unknown Identity of state variables (f
s
) unknown
But, they should forecast something about the economy
Portfolio of wealth is unobservable
It includes are return generating assets (including human
capital and public property)
Transactions costs and illiquidity can delink consumption and
returns at high frequencies
11/3/2011
15
Rolls Critique (1977)
If a portfolio against which returns are measured is ex-
post efficient, then no security will have abnormal
returns
If the portfolio is inefficient then any abnormal return
is possible
If alpha is non zero is it because the market portfolio is If alpha is non-zero is it because the market portfolio is
inefficient or is it because there is mispricing?
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
Rolls Critique (1977) continued
Only true test if the true market portfolio is ex-post
efficient
True market portfolios is unobservable. So, good luck.
Testing CAPM
d O h A P i i M d l and Other Asset Pricing Models
The Market Model
Alphas and betas are measured statistically using
historical returns on the security and the market
portfolio proxy, e.g. S&P 500
Run the regression of the Market Model:
| ] [
Apply this to a particular stock, and you get a Security
Characteristic Line...
it ft mt i i ft it
r r r r c | o + + = ] [
Security Characteristic Line
Equation of Line:
) (
f m f i
r r r r + = | o
40%
50%
60%
P
r
e
m
i
u
m
it ft mt i i ft it
r r r r c | o + + = ] [
Beta=Slope
Alpha=Intercept
-20%
-10%
0%
10%
20%
30%
-15% -10% -5% 0% 5% 10% 15% 20% 25% 30% 35%
Market Risk Premium
S
t
o
c
k

R
i
s
k

P
How to Calculate Beta
Returns are for what period?
Best is annual or quarterly but too few observations
Practice is to use monthly
Make sure that all returns are stated monthly
it ft mt i i ft it
r r r r c | o + + = ] [
Pay attention to the risk free rate, because that is usually stated yearly
Use portfolios to reduce estimation error
Run a CAPM type regression on each stock
Sort stocks into Beta portfolios
Calculate portfolio Betas
Attribute portfolio Betas to each stock
11/3/2011
16
Calculating Googles Beta for real
Calculating Googles Beta for real 2
Predicting Betas
The Beta we just calculated is based on historic data
We need a future beta.
Betas tend to mean revert.
11/3/2011
17
Mean Reversion as Seen with IBMs Betas
When Beta is below the mean (typically 1) betas tend to
rise.
When Beta is above then mean betas tend to fall
Predicting Betas: Correcting for Mean Reversion
In order to correct for mean reversion
Because the average beta is 1
We calculate the following:
1
3
1
3
2
+ = ta HistoricBe Beta Adjusted
CAPM predictions
should be zero.
If not, there may be missing factors.
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
()
Fama-McBeth (1973)
Tests if high beta is associated with high returns and
vice versa.
General format:
Time-series regressions to get betas for test portfolios
Usually beta sorted porttflios
Monthly cross-sectional regressions to test if high beta is 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
General FM73 Algorithm
Use monthly data from years 1 through 7 to estimate CAPM Beta
1-7
for each
company.
Use to rank stocks (rank
1-7
) into 20 equally sized groups (call portfolios
formed on rank
1-7
portfolio
1-7
)
Use monthly data from years 8 through 12 to estimate CAPM Beta
8-12
(= ) for
each company.
Find the average Beta
8-12
and average (equally weighted) return for each
Portfolio in each month of year 13 (i e letting delisted companies to drop Portfolio
1-7
in each month of year 13 (i.e. letting delisted companies to drop
out each month).
Roll one year forward and repeat steps 1-4 till done.
Example in step 1 use data from years 2 through 8
For each month run a cross-sectional regression using the average Betas and
returns calculated in step 4.
Collect the time series of the coefficients (s)
Example from FF92
They look at whether CAPM works.
It doesnt.
Here is what they do:
The sort stocks by size and by the stocks pre-ranking beta.
P ki b b l l d f h k h 5 f Pre-ranking betas: betas are calculated for each stock over the 5 years of
monthly data preceding (not including) the current year (from t-5 to t-
1).
Stocks are sorted by size and then each size portfolio is sorted by the
pre-ranking beta.
For each month in year t, calculate equally weighted portfolio returns
For each size/pre-ranking-beta portfolio calculate Beta for the entire
sample, including one lag of the value weighted market to correct for
non-synchronous trading.
Assign the betas to each stock in the portfolio and run monthly cross-
sectional regressions.
11/3/2011
18
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
Related findings- Fama French 1992 - Size and Beta
Size and Book to Market

Lecture 1 - Nov. 3, 2011

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11/3/2011

2008 Patrick J. Kelly 27

2008 Patrick J. Kelly 44

with short-sale constraints

This structure suggests a natural test for efficiency:

Test of Mean Variance Efficiency

2008 Patrick J. Kelly 68

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