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Extra Slides on Asset Pricing for Day 2

# Extra Slides on Asset Pricing for Day 2

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12/21/2011

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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
×
+
×
=
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

j,t
=
α
j
+
Σ
l=-l1:l2
β
j,l
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

–

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:

j,nt
=
α
j,
n
t
+
β
j
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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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:

i,t
-R
F
=
α
i
+
β
i
(R
M,t
-R
F
) +
ε
i,t
(+
δ
i
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
(f)
is the sample mean of the factor,and
σ
(f)
the sample standard deviation,
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
!
N
!
1
N
1
+
E
( )
ˆ
!
( )
"#\$\$%&''
2
()**+,--
!
1
ˆ
.
ˆ
/
!
1
ˆ
~
N
,
!
N
!
1
E
!
[ ]
=
"
Mean of
é

Cross-sectional tests

Main idea:

i,t
=
γ
0
+
γ
1
β
i
+
ε
i,t
(+
γ
2
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 –

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
(e.g., every month), repeat
–

Time-series
regression over the previous K periods to estimate beta
i,t-k
=
α
i
+
β
i
M,t-k
+
ε
i,t-k
, for k=1:K

–

Cross-sectional
(CS) regression
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
, 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

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