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Extra Slides on Asset Pricing for Day 2Ratings: (0)|Views: 3|Likes: 0

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https://www.scribd.com/doc/76210805/Extra-Slides-on-Asset-Pricing-for-Day-2

12/21/2011

text

original

11/10/111

Predicting Betas: Correcting for Mean Reversion

•

In order to correct for mean reversion

–

Because the average beta is 1

•

We calculate the following:

© 2008 Patrick J. Kelly 97

13132

×

+

×

=

ta HistoricBe Beta Adjusted

Estimating beta for illiquid stocks

•

Assume that the stock is not traded in dates t

1

, t

2

,…•

What would be the prices in the non-traded days?

–

Same as in the last trading day, thus zero return

•

Large return in the first trading day after the break

–

Predicted by the market model: R

t

=

β

*R

M,t

•

In the first trading day after the break, the stock

s return will accumulate allidiosyncratic noise over the non-traded period

•

Betas will be biased!•

Dimson (1979): regression including lead and lag values of the market index•

R

j,t

=

α

j

+

Σ

l=-l1:l2

β

j,l

R

M,t+l

+

ε

j,t

–

True beta is a sum of all lead-lag betas:

Σ

l=-l1:l2

β

j,l

Estimating beta for illiquid stocks

•

The “trade-to-trade” approach:

–

Compute stock returns from the last traded day to the next tradedday (if necessary - over 2, 3 or n

t

days) –

Compute market returns for the same periods –

Run a regression with matched multi-period returns:

•

R

j,nt

=

α

j,

n

t

+

β

j

R

M,nt

+

Σ

t=0:nt-1

ε

j,t

–

How to control for heteroscedasticity?

•

WLS: the variances are proportional to n

t

•

OLS regression with data divided by

√

n

t

(R

j,nt

/

√

n

t

) =

α

j

*

√

n

t

+

β

j

(R

M,nt

/

√

n

t

) + (

Σ

t=0:nt-1

ε

j,t

/

√

n

t

)

What if the stock has a large weight in the index?

•

Endogeneity problem

–

In the extreme, when the index is dominated by one stock, thisstock will have beta of 1 by construction –

In Russia, this is a problem for Gazprom, Lukoil, …

•

How to solve it?

–

Usual way: exclude this stock from the index

–

Theoretical

solution: use IV approach with other blue chips (orindustry indices) as instruments

The evidence

CAPM

© 2011 Patrick J. Kelly 101

CAPM predictions

•

α

should be zero.

–

If not, there may be missing factors.

•

β

is the only relevant factor•

Relation between

β

and returns is linear•

Over long periods the return on the market is greater thanthe risk free return

–

In general, riskier stocks should earn higher return on average

•

Market portfolio is mean-variance efficient•

If you cross-sectionally regress

β

on risk premia, estimatesshould equal the average market risk premium (

λ

)

© 2011 Patrick J. Kelly 102

11/10/112

Related findings- Fama French 1992 - Size and Beta

© 2011 Patrick J. Kelly 103

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11unaNsooCANA
MEaNDsothmthCCMPdarrmaaototh1szpoounthNbnEszdeisuvdino1

f

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ywhMEdmninmoodaTanmosopmhfothszpoointhsmeszdevefm7to1Tanmosofothszpooinszde2a3ibw1a4athanmfothla7szdeibw1a2TAcumshwsacfoewgszde(MEpooTArwshwsacfoewgpooothsoine:gALwf2f3f4f5f6f7f8f9HgPAAMohyRu(nPA1213121313131212121211SmME1517151716151513161514ME21212141313161613131311ME31211131117121113131207ME41212111510131014111309ME51213141314141111121110ME61110151211121211101010ME71009121210111112061307ME81110101312120911101009ME90909081011101209080805LME0810091109090810070705

Testing CAPM

•

Approach 1: time series regression

–

We observe the series of returns of the asset and of the marketindex –

We estimate beta (in-sample) and check whether other variables(const, D/P, P/E, B/M, …) explain remaining time variation in theasset

s return

•

Approach 2: cross-sectional regression

–

We check whether observed betas are (linearly) related to stock returns (as in the Security Market Line)

Time series test

•

Run time series regression for N assets:•

R

i,t

-R

F

=

α

i

+

β

i

(R

M,t

-R

F

) +

ε

i,t

(+

δ

i

X

i,t-1

)•

Usually, N portfolios

–

Grouped by industry / size / … –

To reduce idiosyncratic variation present in individual stocks

•

H

0

:

α

i

=0 (

δ

i

=0) for any i=1,…,N

–

There are no systematic deviations from the return predicted by theCAPM

•

Assuming that R

i,t

~ IID Normal, estimate by OLS

–

F-test for the joint significance of

α

and

δ

coefficients

Results

•

Early tests, up to 80s

–

Did not reject CAPM –

But: betas are unstable over time

•

Gibbons, Ross, and Shanken (1989)

–

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

•

CLM (1997, Table 5.3)

–

Data: US, 1965-1994, monthly returns of 10 size portfolios, VW-CRSP market index –

Joint test rejects CAPM, esp. in the earlier part of the sampleperiod

Fama-French (1993)

•

Run CAPM regressions using 342 months of data for 25 sizeand book-to-market portfolios•

Strongly reject CAPM. F=1.91 with p-value 0.004

© 2010 Patrick J. Kelly 107

Intuition: Tests of Mean Variance Efficiency

•

Cochrane (2001, Chapters 2 and 5) shows that any expectedreturn can be related to any mean-variance efficient portfoliolying on the efficient frontier:•

This structure suggests a natural test for efficiency:•

Test whether

α

is non-zero.

–

This is the basic intuition of most tests of portfolio efficiency

•

Differences across tests are mostly econometric refinements

© 2011 Patrick J. Kelly 108

E r

i

( )

=

r

f

+

!

i

,

mv

E r

mv

( )

!

r

f

"#$%

E r

i

( )

!

r

f

=

!

+

"

i

,

mv

E r

mv

( )

!

r

f

"#$%

11/10/113

Test of Mean Variance Efficiency

•

Gibbons, Ross, Shenken (1989)

–

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

σ

(f)

the sample standard deviation,

T

is the number of observations,

N

is the number of test assets,

1

is the number of factors,

α

is a vector of the intercepts from the N test-assetregressions, and

Σ

is the cross test asset residual covariance matrix,such that

© 2011 Patrick J. Kelly 109

T

!

N

!

1

N

1

+

E

T

f

( )

ˆ

!

f

( )

"#$$%&''

2

()**+,--

!

1

ˆ

.

!

ˆ

/

!

1

ˆ

!

~

F

N

,

T

!

N

!

1

E

!

t

!

!

t

[ ]

=

"

Mean of

é

Cross-sectional tests

•

Main idea:•

R

i,t

=

γ

0

+

γ

1

β

i

+

ε

i,t

(+

γ

2

X

i,t

)•

H

0

: asset returns lie on the SML

–

The intercept is the risk-free rate:

γ

0

= R

F

–

The slope is the market risk premium:

γ

1

= mean(R

M

-R

F

) > 0 –

There are no additional effects:

γ

2

= 0

•

We don

t know true betas!

–

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 expectedreturns (in SML)

–

We need to estimate this cross-sectional regression over many periods (to measure

average

effect)

Two-stage procedure

•

Recursive procedure: for each

t

(e.g., every month), repeat

–

Time-series

regression over the previous K periods to estimate beta

R

i,t-k

=

α

i

+

β

i

R

M,t-k

+

ε

i,t-k

, for k=1:K

–

Cross-sectional

(CS) regression

R

i,t

-R

F

=

γ

0

+

γ

1

β

i

+

ε

i,t

(+

γ

2

β

2i

+

γ

3

σ

i

)

•

Fama-MacBeth approach (first in 1973)

–

Running CS regression for each month

t

, we get the time series of coefficients

γ

0,t

,

γ

1,t

,… –

Compute mean and st. deviation of

γ

s from these time series:

•No need for s.e. of coefficients in the cross-sectional regressions!•Shanken

s correction for the estimation error in betas

–

Assuming normal IID returns, t-statistic =

√

T

γ

avg

/

σ

(

γ

)

Results

•

Fama-MacBeth (1973): estimate CS regression•

R

i,t

-R

F

=

γ

0

+

γ

1

β

i

+

γ

2

β

2i

+

γ

3

σ

2

ε

,i

+

ε

i,t

–

γ

1

> 0: positive effect of beta –

γ

2

= 0: no non-linear effects of beta –

γ

3

= 0: no impact of idiosyncratic risk

•

Cochrane (2001)

–

Sort all NYSE stocks into 10 size deciles, add government andcorporate 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 CAPMCAPM does well in explaining stock vs. bond returns, but poorly inexplaining large vs. small-cap stocks

Cross-Sectional Approach: 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 associated with high return

•

Cochrane (1999) shows that GMM panel regressions areidentical under some assumptions

© 2011 Patrick J. Kelly 114

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