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Business School
Risk and Actuarial Studies


Week 3
Asset Pricing and Market Efficiency
Greg Vaughan

This week’s coverage
Bodie et al
Chapter 9 The Capital Asset Pricing Model
Chapter 10 Arbitrage Pricing Theory and Multifactor
Models of Risk and Return
Chapter 11 The Efficient Market Hypothesis
Chapter 12 Behavioral Finance and Technical Analysis
Chapter 13 Empirical Evidence on Security Returns




From Last week
Portfolio Tracking Error versus Residual Risk
•  Tracking error, the volatility of active return, will be
greater than residual risk when portfolio beta deviates
from one



(TrackingErr)2 = ( β −1) × σ M + σ α
•  In practice tracking error and residual risk, σ α ,are
similar because managers keep beta close to one. Why?
•  Clients don’t like managers who do worse than the index
when the index is negative (ie high beta)
•  More forgiving (to a point) of underperformance in very
strong markets

The road so far

Allocation between a risk free asset and one risky asset
The opportunity set of two risky assets
The Capital Allocation Line and Utility
The separation property
Markowitz and many risky assets
Simplifying risk with a single index model
The security characteristic line




CAPM Assumptions about individual behavior
a.  Investors are rational, mean-variance optimizers. Is the
Utility function properly specified? Higher moments.
Merton’s extramarket risk:

E(Ri ) = βiM E(RM ) + ∑ βik E(Rk )

b.  Their planning horizon is a single period (addressed by
Merton’s Intertemporal CAPM )
c.  Investors have homogenous expectations


CAPM Assumptions about market structure
a. All assets are publicly held and trade on public
exchanges, short positions are allowed and investors can
borrow or lend at a common risk-free rate.
Ø  Black’s zero beta model when borrowing constrained
Ø  Mayer’s unlisted asset model
b. All information is publicly available
c. No taxes (Brennan extension)
d. No transaction costs



10/08/15 Resulting Equilibrium Conditions •  All investors will hold the same portfolio for risky assets – market portfolio •  The market portfolio is efficient •  Risk premium on the market depends on the average risk aversion of all market participants 7 Return and Risk For Individual Securities •  An individual security’s risk premium is a function of the covariance of returns with the assets that make up the market portfolio •  Should not expect reward for non-beta risk as this can be diversified away 8 4 .

rm)] / σm2 = σ m2 / σ m2 = 1 10 5 .rf] Betam = [Cov (ri. •  As a measure of risk (high beta is dangerous) •  Generally robust as assumptions are relaxed (ie the modified forms resemble the simple form) •  Still in active use a half century later 9 Security Market Line Expected return-beta relationship Expected returns are commensurate with their risk Individual asset risk premium as a function of asset risk Benchmark for performance evaluation ‘Fairly priced’ assets plot exactly on the SML β = [COV(ri.rf = market risk premium SML = rf + β[E(rm) .10/08/15 What’s good about the CAPM •  Mechanism for pricing assets – fills a void •  Useful in capital budgeting decisions .provides a basis for required rate of return. Applied in utility regulation.rm)] / σm2 Slope SML = E(rm) .

08 Rm=11% Ry=7.8% 3% .25 βx 11 Disequilibrium Example E(r) SML 15% Rm=11% rf=3% 1.6 βy 1.10/08/15 In equilibrium expected returns are linear in beta E(r) SML Rx=13% .0 β 1.25 β 12 6 .0 1.

but that can be because of weak statistical power in the context of noisy data (ample scope for Type II error) •  CAPM does not assume stationary risk. 14 7 . •  Null hypothesis usually of the form ‘there is no relation between beta and return’ •  Tests have sometimes failed to reject this null.test results are very sensitive to market definition.10/08/15 SML and Alpha •  Expected alpha = expected return – SML return •  Expected alphas should be zero in an efficient market •  If an investor perceives non-zero expected alphas they may be delusional – the market may still be efficient •  If a good proportion of managers expect and realise alphas consistently over time then the market may not be perfectly efficient •  A minority of well performing managers is inconclusive evidence about market efficiency 13 9-13 CAPM testing •  Arbitrary market definition – really tests of single index model •  Roll’s critique . Inextricably linked to market efficiency. but tests typically do.

10/08/15 CAPM testing controversy •  Fama and French (1992) ‘The Cross-Section of Expected Return’ – no relationship between betas and returns (1963-1990) •  Chan and Lakonishok (1992) ‘Are the reports of Beta’s death premature?’ – looked at data for 1926-1991. and financial leverage which all drive volatility. 16 8 . •  Using data before the ‘discovery’ of CAPM to support CAPM is curious •  General acceptance that high beta stocks underperform in downturns so useful risk measure. Problems only from 1982. •  What is the appropriate market index? Should Australian resource stock betas be against the local or a global index? •  Expect betas to vary especially by industry. High frequency estimation is problematic. Companies evolve over time. operational leverage (cyclicality). 15 Beta Estimation •  A regression approach needs to consider span of historical data and frequency. Beware if estimation contradicts common sense.

1975) ∧ β = w × βOLS + (1− w) ×1 where w is constant for all stocks (eg 2/3) 17 Practical Beta Estimation (2) •  Vasicek (1973) – stock specific bayesian adjustment ∧ β = w × βOLS + (1− w) × β Pr ior where w= β Pr ior S b Sb! S 2b ( S + Sb$2 ) 2 b May be a typical sector beta based on longer data series of sector versus market index performance is the typical Beta standard error. eg the median Beta standard error across all stocks is the Beta standard error for this stock (if it is lower than median then the credibility weight exceeds 0.5) 18 9 .10/08/15 Practical Beta Estimation (1) •  Betas seem to drift towards 1 over time – Blume (1971.

10/08/15 Practical Beta Estimation (3) •  Thin trading can lead to low beta estimates – trade to trade estimation. An OLS approach implicitly assumes stationarity (constant profile over estimation and forecast period). 20 10 . Dimson and Marsh (1983) •  Direct Leverage Adjustment β L = βU × (1+ (1− t) ( D / E )) if a stock has the same unlevered beta as the market its beta can still be different to one due to leverage 19 Using Firm Variables to Help Predict Betas (Barra): Rosenberg and Guy 1976 found following: •  Variance of earnings •  Variance of cash flows •  Growth in earnings per share •  Market capitalisation •  Dividend yield •  Debt-to-asset ratio This approach allows for change in the stocks profile over time.

10/08/15 Early Factor Model Perspective Returns on a security come from two sources –  Common macro-economic factor –  Firm specific events Macro factor derives from a range of influences –  Business cycle –  Interest Rates –  Inflation A single composite factor (eg market index) assumes each stock has the same relative sensitivity to underlying subfactors 21 Multifactor Model Example Ri = E(Ri) + BetaGDP (GDP) + BetaIR (IR) + ei Ri = Excess return for security i GDP = GDP deviation from expected BetaGDP= Factor sensitivity to GDP deviation IR = Interest rate deviation from expected BetaIR = Factor sensitivity for Interest Rate deviation ei = return due to firm specific events 22 11 .

regardless of risk aversion or of one price Elimination of arbitrage opportunity Investor. trades the arbitrage – a stronger argument than risk-return dominance 23 Portfolios and Individual Security E(r)% E(r)% F F Portfolio Individual Security 24 12 .10/08/15 Arbitrage Pricing Theory APT was developed by Stephen Ross in 1976 Relies on three key propositions: •  Security returns can be described by a factor model •  Well-functioning security markets don’t allow for the persistence of arbitrage opportunities •  There are sufficient securities to diversify away idiosyncratic (firm specific) risk An arbitrage opportunity .

5 1. and short C •  Arbitrage because combined position is risk neutral with positive return 26 13 .0 Beta for F 25 Disequilibrium Example •  Portfolios A and C are out of alignment •  Construct a Portfolio D with equivalent risk.10/08/15 Disequilibrium Example E(r)% 10 7 A D 6 C Risk Free 4 . but higher return than Portfolio C •  D is comprised of A and the risk-free asset •  Invest long in D.

factor exposures need to be estimated) •  Fundamental corporate factors (observable factor exposures. from where? Macro and micro common factors: •  Important macro factors (observable factor returns.10/08/15 Figure  10.2  Returns  as  a  Function  of  the   Systematic  Factor:  An  Arbitrage  Opportunity   27 Factors. but factor returns need to be estimated) 28 14 .

Roll.10/08/15 Factors. •  •  •  •  •  •  choose the following factors based on the ability of these factors to explain return: IP = % change in industrial production EI = % change in expected inflation UI= % change in unexpected inflation CG = corporate bond spread GB = yield curve slope Rit = α i + βiIP IPt + βiEI EI t + βiUIUI t + βiCG CGt + βiGBGBt + eit 29 Fama and French Three-Factor Model Rit = α i + βiM RMt + βiSML SMBt + βiHML HMLt + eit SMB = Small – Big Portfolio HML = High – Low •  Firms with high ratio of book to market value are more likely to be in financial distress •  Small stocks may be more sensitive to changes in business conditions (These variables may capture sensitivity to risk factors in the macro economy) Now really a four factor model as F&F acknowledge this version doesn’t explain momentum (Carhart. and Ross (1989) JOB. from where? Chen.59. vol. 1997) 30 15 .

momentum.σ (Fk ) is significant (ie a risk factor) •  Unless E(Fk ) is significantly positive a portfolio manager would seek to have the same exposure as the benchmark to a risk factor n n ∑w β = ∑w β p i=1 ik b ik i=1 •  The goal of active management is to identify factors with a significantly positive expectation relative to their volatility and take greater exposure to these factors than the benchmark (eg value. quality) 32 16 .10/08/15 APT and CAPM Compared •  APT applies to well diversified portfolios and not necessarily to individual stocks •  With APT it is possible for some individual stocks to be mispriced – not lie on the SML •  APT is more general in that it gets to an expected return and beta relationship without the assumption of the market portfolio or universal mean-variance optimisation •  APT can be extended to multifactor models •  The CAPM provides an unambiguous statement on the relationship between E(R) and Beta for all securities •  Whereas APT implies that this relationship holds for all but perhaps a small number of securities 31 Multifactor Models and active management f Ri = ∑ βik Fk + ei k=1 •  A factor may be of interest in portfolio construction because it is volatile .

there is beta! 34 17 . wb: σ 2 b = Wb! •∑•Wb The vector of stock betas is then simply β= ∑⋅wb σ b2 Where there is a factor structure. The portfolio variance. the covariance of factor returns (F) and the diagonal matrix of stock idiosynchratic variances (Δ).10/08/15 Multi-factor models and volatility The covariance matrix of stock returns ∑ = X • F • X"+ Δ nxf nxn fxf fxn nxn The covariance matrix builds from stock factor exposures (X). from the vector of portfolio weights. wp. is then: σ 2 p = Wp! •∑•Wp 33 Beta against a benchmark The variance of benchmark returns similarly derives from the vector of benchmark weights.

10/08/15 Efficient Market Hypothesis (EMH) •  Do security prices reflect information? •  Why look at market efficiency? –  Active versus passive investment management –  Corporate finance and CAPM –  Market integrity •  Market efficiency refers to information reflected in prices. portfolio efficiency refers to minimum volatility at a level of expected return 35 Random Walk and the EMH •  The ‘random walk’ of the market index is a different question to stock price movements relative to the market •  Randomness is not the same as irrationality •  Random Walk – the concept is stock prices are random –  Actually submartingale •  Expected price trend is positive over time •  Positive trend and random about the trend •  This is very different to a trend reverting stationary process embedded in traditional ALM models •  ‘Random walk’ abstracts from the underlying connection to company value and how it evolves – statistically naive 36 18 .

price changes are random 38 19 .10/08/15 Random Walk with Positive Trend Security Prices Time 37 Random Price Changes Why are price changes random? •  Prices react to information •  Flow of information is random •  Therefore.

To be believed an anomaly requires firm empirical support and convincing rationale. 40 20 . products.10/08/15 Random Walk and the EMH •  Volatility of log returns can be calculated at different data frequencies (eg annual. monthly) •  If there is true independence from one period to the next the results should be consistent (ie variance ratios of 1) •  There is some mild statistical contradiction of the random walk in Australia (1980-2012) 39 Three levels of the Efficient Markets Hypothesis •  Weak-form – information derived from market trading data including past prices. trading volumes and short interest •  Semi-strong-form – publicly available information including fundamental data on financial reports. earnings forecasts •  Strong-form – all information including information only available to company insiders A contradiction of market efficiency is referred to as an ‘anomaly’. quarterly. management.

10/08/15 Weak-form market efficiency (1) Tests of weak-form efficiency are specific to how the dependent variable is defined. or •  The cross-sectional variation of stock returns for a period (eg month) across the market. 41 Weak-form market efficiency (2) There a three basic patterns recognised in research into the momentum of stock prices relative to the market •  A longer term reversal over multiple years (ie winners eventually become losers) •  An intermediate momentum where trailing 3 -12 month performance continues (winners continue to win) •  A very short term reversal effect where trailing returns (days. weeks) quickly reverse because of liquidity effects 42 21 . Are we interested in: •  The variation through time of the market index. or •  The cross-sectional variation of stock returns within their sector (eg a mining stock relative to other mining stocks) The rejection. of the weak-form EMH in a specific context is not a general result. or acceptance.

The Profitability of Momentum Strategies ‘Price momentum strategies may exploit slow reaction to a broader set of value-relevant information. 2005. including the long-term prospects of companies that have not been fully captured by near-term earnings forecasts or past earnings growth’ 43 Weak-form market efficiency (4) Scowcroft and Sefton. 1999. whereas small cap momentum is exploited by shorting losers – asymmetry matters 44 22 . Jegadeesh and Lakonishik. momentum happens at the industry level •  If sector allocation is controlled a portfolio will not be exposed to this momentum effect •  For small stocks momentum is more stock specific •  Large cap momentum is best exploited by overweighting winners.10/08/15 Weak-form market efficiency (3) Chan. Understanding Momentum •  Global data 1980-2003 •  For large stocks.

10/08/15 Weak-form market efficiency (5) Garcia-Feijoo. lowest-risk stocks tend to outperform the highest-risk stocks in some periods •  The effect is strongest when the prices of low risk have been discounted relative to high risk stocks (eg towards the end of the 2000 tech bubble) •  ‘Low-risk’ portfolios often exhibit value and momentum exposures which substantially contribute to their performance •  There have been extended periods when high-risk stocks outperform eg after recessions 45 Semi-strong-form market efficiency (1) Chan and Lakonishik. Sullivan and Wang. 2015. and brokers find them easier to sell 46 23 . Low-Volatility Cycles: The Influence of Valuation and Momentum on LowVolatility Portfolios •  US data 1930-2012 •  Contradicting CAPM. Value and Growth Investing: Review and Update •  Value returns are not explained by risk – value stocks are not riskier stocks •  Value stocks have outperformed glamour stocks in times of market distress •  Investors and brokers wrongly extrapolate past growth rates of earnings. Kochard. cash flow and sales and value stocks often have poor financial track records which reverse •  Investment managers and their clients feel better about holding glamour stocks. 2004.

although subsequent research has narrowed the effect to smaller companies. 48 24 . Where is the Value Premium? •  US data 1980-2001 •  Most of the value premium comes from stocks with low levels of institutional ownership •  The value anomaly can survive in this tier of the market because it is difficult to arbitrage away •  Where it occurs it is exploited by buying undervalued stocks rather than selling overvalued stocks 47 Semi-strong-form market efficiency (3) Sloan. Do Stock Prices Fully Reflect Information in Accruals and Cash Flow About Future Earnings? •  The accrual ‘boost’ to reported earnings is revealed by comparing the profit and loss (accrual based) to the cash flow statement •  Where earnings have been ‘boosted’ there is a tendency for profit growth reversal in subsequent years •  Investors are surprised by this reversal so high accrual stocks underperform •  A simple anomaly against semi-strong-form efficiency.10/08/15 Semi-strong-form market efficiency (2) Phalippou. 2008. 1996.

10/08/15 Strong-form market efficiency Event studies look for market leakage ahead of announcement – insider effect. 49 Strong-form market efficiency (2) Earnings Surprise 50 25 .

Micro stocks behave differently. especially with high turnover strategies •  Are results dependent on the particular time period analysed 52 26 . •  Is the anomaly symmetric (ie works on long and short side) •  Have confounding effects (eg size and sector) been properly controlled. and portfolio formation/regression? •  Is the stock sample representative of the investment universe for institutional managers? Full market versus broad market.10/08/15 Strong-form market efficiency (3) Dividend Surprise 51 What to look for in market anomaly investigations •  What are the specifics of return horizon. Do results vary across size and sector? •  Have transaction costs been allowed for. Treat unweighted results with suspicion.

rather than invoked in an attempt to explain results 53 Behavioural Finance (2) Prospect Theory •  Choice A: a certain gain of $50 or a 50/50 gamble between zero and $100 •  Choice B: a certain loss of $50 or a 50/50 gamble between zero and a $100 loss explanation for results. 54 27 .10/08/15 Behavioural Finance •  Historically finance theory has typically assumed investors are objective and rational •  Behavioural finance explores how and why investors actually behave •  Most anomaly investigations will attempt a behavioural explanation for the anomaly uncovered •  Research proceeds more scientifically if the behavioural explanation is integral to the hypothesis tested.

•  ‘A person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise’ – Kahneman and Tversky 55 Behavioural Finance (4) Overconfidence/ attribution bias/ hindsight bias •  Investors over-estimate the accuracy of their knowledge and overrate their own abilities •  Overconfidence is fed by self attribution bias whereby past successes are attributed to skill. and failures to factors beyond their control •  Attribution bias can also involve attributing causes to random events. and mute negative reaction by deferred selling. Investors mute positive price reaction by premature taking of gains.10/08/15 Behavioural Finance (3) Prospect Theory •  Investors are loss averse •  They are inclined to sell their winners and hold their losers to postpone the regret of incurring a loss •  This is consistent with a gradual reaction of markets to new information. mistaking simple coincidence •  Hindsight bias – investors over-estimate the probability they assigned to an event that has occurred •  Overconfidence is stronger for more diffuse tasks where feedback is slow (eg short-term versus long-term forecasts) 56 28 .

10/08/15 Behavioural Finance (5) Representative heuristic •  Wrongly assuming small samples to be highly representative of the parent population from which they are drawn •  We tend to give too much weight to information that is recent. bad. frequent or extreme 57 Behavioural Finance (6) Under-reaction/ confirmation bias •  contributed by overconfidence •  Confirmation bias assigns more importance to information that confirms prior views •  Contradictory information is downweighted •  Investors are poor Bayesians – too anchored to their prior beliefs •  This bias is a supporting rationale for momentum and earnings revision anomalies 58 29 .

59 Behavioural Finance (7) Summary •  A proper statistical mindset guards against many of the biases of behavioral finance •  The synthesis of under-reaction (momentum) and overreaction(value) is that ‘the market is slow to overreact’ 60 30 . Shleiffer and Vishny 1994 ‘Contrarian investment.10/08/15 Behavioural Finance (6) Over-reaction •  Investors exaggerate optimism and pessimism over the medium term •  this is a supporting rationale for the value anomaly whereby stocks that have underperformed over a period eventually reverse and appreciate •  Lakonishok. Extrapolation and Risk’ showed that value (cheap) stocks tended to have prior histories of low sales and earnings growth.

62 31 .10/08/15 Kenneth French Data Library (KFDL) •  Simple portfolio calculations on the US market since 1927 (monthly and yearly). High Book-to Market (top 30%). Rough passage through GFC. Sorts on various value and momentum definitions •  Insight into performance variation over time •  Annual portfolio review so portfolio characteristic fades over the year – not representative of actual portfolio management •  Momentum definition is trailing months 2-12. ‘Small’ effectively refers to micro cap as break point is median market value across entire market 61 ‘Value’ returns in the US market (KFDL) ‘Large’ (broad cap). valueweighted portfolio returns relative to market (annual and rolling ten year). excludes reversal •  ‘Large’ refers to broad market/investible.

10/08/15 ‘Momentum’ returns in the US market (KFDL) ‘Large’ (broad cap). High Momentum (top 30%). 63 Australian Equity Manager Performance Mercer Survey – Rolling 3 Year Quartiles and Median Past performance is not a reliable indicator of future performance. value-weighted portfolio returns relative to market (annual and rolling ten year). You should not rely on past performance to make investment decisions 64 32 .

FTSE/ASFA.periods ending June 2015 Sources: S&P/ASX. SuperRatings Active Management contribution is Mercer survey median minus S&P/ASX 200 Tax Effect is FTSE ASFA Superannuation Index less non-tax adjusted index Super Fund Fees are estimated from a survey of Fund Product Disclosure Statements Median Super Fund is from SuperRatings (SR50) Australian Share Options Survey. Mercer. You should not rely on past performance to make investment decisions 66 33 . configuration and implementation of changes 65 Australian Equity Manager versus Fund Performance . Past performance is not a reliable indicator of future performance. particularly for less experienced Investment Committee members •  The sales techniques of fund managers also play a role •  Outcomes can be compromised by deficiencies in manager selection.10/08/15 Superannuation funds and equity managers •  Each superannuation funds will employ a number of Australian equity managers •  The hiring and firing of managers should reflect relative assessments of capabilities and manager configuration •  Funds are supported by a narrow group of asset consultants •  Past performance is a distraction.

and 9.5%pa net compared to 10.7% for the index. sweeping cash to external managers) 68 34 . estimated at -1. •  The median Fund Manager has done well – in this case they are not the problem.8%pa gross •  Once we adjust for the impact of fees and positive tax effect. there is a significant deficit attributable to the decisions of Superannuation Funds. adding 0.0%pa over the last five years.5%pa gross for the manager median.10/08/15 Superannuation funds or equity managers – who’s the villain? •  Manager performance is surveyed before fees and tax whereas super fund performance is surveyed net •  Over the past five years the Superannuation Fund median for Australian Equity options is 9. 67 How Superannuation Fund decisions impact on performance •  Manager selection decisions – which managers are employed and how funds are allocated across the manager mix •  The timing of manager hiring and firing relative to the manager performance cycle – tendency to reactively hire after good performance and terminate after bad performance •  Transition management – controlling the transaction costs and market exposure as funds move between managers •  Tax management at the Fund level – usually rely on custodian for parcel selection (may not be intelligent parcel selection) •  Exposure management for excess liquidity (ie covering cash with futures.

10/08/15 The case for passive management •  Passive management involves simply matching the index performance at the gross level by replicating the index portfolio (or tracking closely) •  The argument for passive is not just about whether some managers can reliably outperform this index portfolio •  Superannuation Funds need to be able to consistently identify which managers can outperform! •  Then the Superannuation Funds have to time their hiring and firing effectively •  Survey results suggest that the typical Superannuation Fund would do better if they avoided the active management game 69 US Large Cap Equity Manager Performance Mercer Survey – Rolling 3 Year Quartiles and Median Past performance is not a reliable indicator of future performance. You should not rely on past performance to make investment decisions 70 35 .

3 – Black Litterman Model •  Group E ‘Portfolio Constraints and the Fundamental Law’ •  Group E ‘Facing The Reality of Bubble Risk’ 72 36 .3 and two assigned papers thoroughly •  Group D Section 27. You should not rely on past performance to make investment decisions 71 Next week •  Read Text Section 27.10/08/15 World ex US Equity Manager Performance Mercer Survey – Rolling 3 Year Quartiles and Median Past performance is not a reliable indicator of future performance.

10/08/15 Thank you for your attention Greg Vaughan School of Risk and Actuarial Studies University of New South Wales 73 37 .