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Outline

Motivation

Time-series approach

Cross-sectional approach

Comparing approaches

Odds and ends

2 Event Studies

Motivation

Basic methodology

Bells and whistles

Linear Factor Models Motivation

Outline

Motivation

Time-series approach

Cross-sectional approach

Comparing approaches

Odds and ends

2 Event Studies

Motivation

Basic methodology

Bells and whistles

Linear Factor Models Motivation

Many asset pricing models can be expressed in linear factor form

E[rt+1 r0 ] = 0

| {z }

Note that in the CAPM the factor is an excess return that itself

must be priced by the model an extra testable restriction.

Michael W. Brandt Methods Lectures: Financial Econometrics

Linear Factor Models Motivation

Econometric approaches

literature on estimating and testing these models.

Time-series regression based intercept tests for models in

which the factors are excess returns.

Cross-sectional regression based residual tests for models in

which the factors are not excess returns or for when the

alternative being considered includes stock characteristics.

The aim of this first part of the lecture is to survey and put into

perspective these econometric approaches.

Linear Factor Models Time-series approach

Outline

Motivation

Time-series approach

Cross-sectional approach

Comparing approaches

Odds and ends

2 Event Studies

Motivation

Basic methodology

Bells and whistles

Linear Factor Models Time-series approach

the model, the factor risk premium is identified through

T [ft+1 ].

=E

With the factor risk premium fixed, the model implies that the

intercepts of the following time-series regressions must be zero

e

ri,t+1 r0 ri,t+1 = i + i ft+1 + i,t+1

e

so that E[ri,t+1 ] = i .

Linear Factor Models Time-series approach

The model implies, of course, that all intercepts are jointly zero,

which we test with standard Wald test

])1

0 (Var[ 2N .

To evaluate Var[

] requires further distributions assumptions

" #1

1 1 ET [ft+1 ]

Var = T [f 2 ]2

T ET [ft+1 ] E t+1

which implies !2

1 T [ft+1 ]

E

Var[

] = 1+ .

T

T [ft+1 ]

Linear Factor Models Time-series approach

Assuming further that the residuals are iid multivariate normal, the

Wald test has a finite sample F distribution

!2 1

(T N 1)

ET [ft+1 ]

1+ 0

1

FN,T N1 .

N

T [ft+1 ]

T [r e ] 2

! !2

E T [r e

E ]

q,t+1 m,t+1

e e

(T N 1)

[r

T q,t+1 ]

T m,t+1 ]

[r

,

N

! 2

T [r e

E ]

m,t+1

1+

e

T [rm,t+1 ]

ex-ante mean variance portfolio (i.e., the market portfolio).

Michael W. Brandt Methods Lectures: Financial Econometrics

Linear Factor Models Time-series approach

When the residuals are heteroskedastic and autocorrelated, we

can obtain Var[

] by reformulating the set of N regressions as a

GMM problem with moments

T rt+1 ft+1 T t+1

gT () = E =E =0

(rt+1 ft+1 )ft+1 t+1 ft+1

1 h 1 0 i1

Var = DS D

T

with " #

gT () 1 T [ft+1 ]

E

D= = T [f 2 ] IN

ET [ft+1 ] E t+1

" 0 #

X t tj

S= E .

t ft tj ftj

j=

Linear Factor Models Cross-sectional approach

Outline

Motivation

Time-series approach

Cross-sectional approach

Comparing approaches

Odds and ends

2 Event Studies

Motivation

Basic methodology

Bells and whistles

Linear Factor Models Cross-sectional approach

Cross-sectional regressions

When the factor is not an excess return that itself must be priced

by the model, the model does not imply zero time-series intercepts.

proportional to the time-series betas in two steps

1. Estimate asset-by-asset i through time-series regressions

e

rt+1 = a + i ft+1 + t+1 .

regression of average excess returns on these betas

T [r e ] = i + i .

rie = E i

Linear Factor Models Cross-sectional approach

OLS estimates

The cross-sectional OLS estimates are

= (0 )

1 (r e )

i

e

= r .

i

Var[

]1

2N1

with

1 0 1 I (

Var[] = I ( 0 ) 0 )

1 0

T

Two important notes

Var[

] is singular, so Var[ ]1 is a generalized inverse and

the 2 distribution has only N 1 degrees of freedom.

Testing the size of the residuals is bizarre, but here we have

additional information from the time-series regression (in red).

Michael W. Brandt Methods Lectures: Financial Econometrics

Linear Factor Models Cross-sectional approach

GLS estimates

are likely correlated, it makes sense to instead use GLS.

GLS = (0 1

1 1 r e )

) ( i

and

1 0 1 1 0

Var[

GLS ] = ( ) .

T

Linear Factor Models Cross-sectional approach

Shanken (1992)

The generated regressor problem, the fact that is estimated in

the first stage time-series regression, cannot be ignored.

Corrected estimates are given by

!

1 0 1 I (

0 )

0 )

1 0 2

OLS ] = I (

Var[ 1+ 2

T f

!

1 2

Var[

GLS ] = ( 0 1 1 0 1 +

)

T f2

In the case of the CAPM, for example, the Shanken correction for

annual data is roughly

T [rmkt,t+1 ] 2

!

0.06 2

E

1+ =1+ = 1.16

T [rmkt,t+1 ] 0.15

Linear Factor Models Cross-sectional approach

Formulating cross-sectional regressions as GMM delivers an

automatic "Shanken correction" and allows for non-iid residuals.

The GMM moments are

e a f

rt+1 t+1

e a f

gT () = ET [rt+1 (rt+1 = 0.

t+1 )ft+1

rt+1

The third row over-identifies

If those moments are weighted by 0 we get the first order

conditions of the cross-sectional OLS regression.

If those moments are instead weighted by 0 1 we get the

first order conditions of the cross-sectional GLS regression.

Everything else is standard GMM.

Michael W. Brandt Methods Lectures: Financial Econometrics

Linear Factor Models Cross-sectional approach

Linear factor models can be rexpressed in SDF form

e

E[mt+1 rt+1 ] = 0 with mt+1 = 1 bft+1 .

e e e

0 = E[(1 bft+1 )rt+1 ] = E[rt+1 ] b E[rt+1 ft+1 ]

| {z }

e e

Cov[rt+1 , ft+1 ] + E[rt+1 ]E[ft+1 ]

and solve for

e b e

E[rt+1 ]= Cov[rt+1 , ft+1 ]

1 bE[ft+1 ]

e ,f

Cov[rt+1 t+1 ] bVar[ft+1 ]

= .

Var[ft+1 ] 1 bE[ft+1 ]

| {z }| {z }

Linear Factor Models Cross-sectional approach

This SDF view suggests the following GMM approach

T (1 + bft+1 )r e e e

gT (b) = E t+1 = ET [rt+1 ] b ET [rt+1 ft+1 ] = 0.

| {z }

pricing errors =

whether the pricing errors are jointly zero in population.

Cross-sectional OLS regression of average returns on the

second moments of returns with factors (instead of betas)

when the GMM weighting matrix is an identity.

Cross-sectional GLS regression of average returns on the

second moments of returns with factors when the GMM

weighting matrix is a residual covariance matrix.

Linear Factor Models Cross-sectional approach

The Fama-MacBeth procedure is one of the original variants of

cross-sectional regressions consisting of three steps

1. Estimate i from stock or portfolio level rolling or full sample

time-series regressions.

2. Run a cross-sectional regression

e

rt+1 = t+1 + i,t+1

t ,

{ i,t }Tt=1 .

1 PT i = 1 PT

i = i,t and

t=1 i,t .

T t=1 T

Linear Factor Models Comparing approaches

Outline

Motivation

Time-series approach

Cross-sectional approach

Comparing approaches

Odds and ends

2 Event Studies

Motivation

Basic methodology

Bells and whistles

Linear Factor Models Comparing approaches

Time-series regressions

Avg excess returns versus betas on CRSP size portfolios, 1926-1998.

Linear Factor Models Comparing approaches

Cross-sectional regressions

Avg excess returns versus betas on CRSP size portfolios, 1926-1998.

Linear Factor Models Comparing approaches

SDF regressions

Avg excess returns versus predicted value on CRSP size portfolios, 1926-1998.

Linear Factor Models Comparing approaches

CRSP size portfolios, 1926-1998.

Linear Factor Models Odds and ends

Outline

Motivation

Time-series approach

Cross-sectional approach

Comparing approaches

Odds and ends

2 Event Studies

Motivation

Basic methodology

Bells and whistles

Linear Factor Models Odds and ends

Firm characteristics

So far

H0 : i = 0 i = 1, 2, ..., n

HA : i 6= 0 for some i

more specific alternative in mind

H0 : i = 0 i = 1, 2, ..., n

HA : i = 0 xi

We can test against this more specific alternative by including the

characteristics in the cross-sectional regression

rie == i + 0 xi + i .

Linear Factor Models Odds and ends

Portfolios

Stock level time-series regressions are problematic

Way too noisy.

Betas may be time-varying.

1. Each portfolio formation period (say annually), obtain a noisy

estimate of firm-level betas through stock-by-stock time series

regressions over a backward looking estimating period.

2. Sort stocks into "beta portfolios" on the basis of their noisy

but unbiased "pre-formation beta".

beta, should have relatively constant portfolio betas through time,

and should have a nice beta spread in the cross-section.

Linear Factor Models Odds and ends

Characteristic sorts

exposures got replaced by sorting on firm characteristics xi .

residuals) insead of betas (the regressor).

1. Characteristic sorted portfolios may not have constant betas.

2. Characteristic sorted portfolios could have no cross-sectional

variation in betas and hence no power to identify .

Linear Factor Models Odds and ends

Linear Factor Models Odds and ends

Conditional information

In a conditional asset pricing model expectations, factor

exposures, and factor risk premia all have a time-t subscripts

Et [rt+1 r0 ] = t0 t .

Nevertheless, there are at least two ways to proceed

1. Time-series modeling of the moments, such as

t = 0 (t1 0 ) + t .

t = 0 Zt or t = 0 Zt .

Michael W. Brandt Methods Lectures: Financial Econometrics

Linear Factor Models Odds and ends

In the context of SDF regressions

e

Et [mt+1 rt+1 ] = 0 with mt+1 = 1 bt ft+1 .

e

Et (1 (0 + 1 Zt )ft+1 ) rt+1 = 0.

Condition down

e e

E Et [(1 (0 + 1 Zt )ft+1 )rt+1 ] = E (1 (0 + 1 Zt )ft+1 )rt+1 = 0.

e

E (1 0 f1,t+1 1 f2,t+1 )rt+1 = 0,

Michael W. Brandt Methods Lectures: Financial Econometrics

Event Studies Motivation

Outline

Motivation

Time-series approach

Cross-sectional approach

Comparing approaches

Odds and ends

2 Event Studies

Motivation

Basic methodology

Bells and whistles

Event Studies Motivation

delayed impact of a specific event on the value of a security.

Does this event matter? (e.g., index additions)

but are increasingly used to also answer the question

Is the relevant information impounded into prices immediately

or with delay? (e.g., post earnings announcement drift)

Event studies are popular not only in accounting and finance, but

also in economics and law to examine the role of policy and

regulation or determine damages in legal liability cases.

Event Studies Motivation

Short-horizon event studies examine a short time window, ranging

from hours to weeks, surrounding the event in question.

allows us to focus on the information being released and (largely)

abstract from modeling discount rates and changes therein.

statistical properties of short-horizon event studies.

longer-horizon questions. (e.g., do IPOs under-perform?)

are sensitive to the modeling assumption for expected returns.

Event Studies Basic methodology

Outline

Motivation

Time-series approach

Cross-sectional approach

Comparing approaches

Odds and ends

2 Event Studies

Motivation

Basic methodology

Bells and whistles

Event Studies Basic methodology

Setup

Ball and Brown (1968) and Fama et al. (1969).

1. Event Definition and security selection.

2. Specification and estimation of the reference model

characterizing "normal" returns (e.g., market model).

3. Computation and aggregation of "abnormal" returns.

4. Hypothesis testing and interpretation.

meat of an event study the rest is fairly mechanical.

Event Studies Basic methodology

Reference models

Constant expected returns

ri,t+1 = i + i,t+1

Market model

ri,t+1 = i + i rm,t+1 + i,t+1

Linear factor models

(Notice the intercepts.)

to the choice of reference models, so keeping it simple is fine.

Event Studies Basic methodology

the estimation window and held fixed over the event window.

Event Studies Basic methodology

Abnormal returns

Using the market model as reference model, define

i, = ri,

AR i i rm, = T1 + 1, ..., T 2.

" #

m ) 2

h

i, =

i 1 (rm,

Var AR 2i + 1+ .

T1 T0

m

| {z }

due to estimation error

in the measured abnormal returns, even when true returns are iid,

which is an issue particularly for short estimation windows.

Event Studies Basic methodology

returns are typically aggregated in two dimensions.

1. Average abnormal returns across all firms undergoing the

same event lined up in event time

AR = 1 PN AR i, .

N i=1

2. Cumulate abnormal returns over the event window

i (T1 , T2 ) = PT2

CAR

=T1 +1 AR i,

or PT2

CAR(T1 , T2 ) =

=T1 +1 AR .

Event Studies Basic methodology

Hypothesis testing

Basic hypothesis testing requires expressions for the variance of

i (T1 , T2 ), and CAR(T

, CAR

AR 1 , T2 ).

h i

Var CAR i (T1 , T2 ) = (T2 T1 ) 2 .

i

depend on the cross-sectional correlation of event returns.

= 1 PN 2

Var AR

N 2 i=1 i

PT2

Var CAR(T 1 , T2 ) = =T1 +1 Var AR .

Event Studies Basic methodology

Example

Earnings announcements

Event Studies Bells and whistles

Outline

Motivation

Time-series approach

Cross-sectional approach

Comparing approaches

Odds and ends

2 Event Studies

Motivation

Basic methodology

Bells and whistles

Event Studies Bells and whistles

Dependence

correlated contemporaneously or at lags.

Form a portfolio of firms experiencing an event in a given

month or quarter (still lined up in event time, of course).

Compute the average abnormal return of this portfolio.

Normalize this abnormal return by the standard deviation of

the portfolios abnormal returns over the estimation period.

Event Studies Bells and whistles

Heteroskedasticity

1. Cross-sectional differences in i .

.

Standardize ARi, by i before aggregating to AR

Jaffe (1974).

Cross-sectional estimate of Var [ARi, ] over the event window.

Boehmer et al. (1991).

Event Studies Bells and whistles

An event study can alternatively be run as multivariate regression

L

X

r1,t+1 = 1 + 1 rm,t+1 + 1, D1,t+1, + u1,t+1

=0

L

X

r2,t+1 = 2 + 2 rm,t+1 + 2, D2,t+1, + u2,t+1

=0

...

L

X

rn,t+1 = n + n rm,t+1 + n, Dn,t+1, + un,t+1

=0

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