Quantitative Investing

topics: Recap, CAPM, Factor Models

Week 2

Martijn de Vries
m.vries@vu.nl
This week

• Any questions?

• Deadline Wednesday 12.00

• Hand-in referee report via canvas!
• Sign-up for replications assignment (also by yourself)

• Last week we discussed preferences, utility functions and arbitrage pricing.

→ This week we go from utility functions to portfolio choice.
→ We discuss the empirical performance of CAPM.
→ How to statistically test this performance.
→ Alternative factor models.

• Intro by quizzz!

2
Recap of week 1

3
Recap

• Axioms
A1 Completeness: ∀ x, y ∈ X , x ⪰ y or y ⪰ x.
A2 Transitivity: ∀ x, y, z ∈ X , if x ⪰ y and y ⪰ z ⇒ x ⪰ z.
A3o Continuity: ∀x ∈ X , the subsets of strictly preferred and strictly worse
choices are both open.
A3c Archimedean: ∀P, Q, R ∈ P if P ≻ Q ≻ R, then there exists π1 , π2 ∈ (0, 1)
and a unique π ∗ ∈ (0, 1) such that
π1 P(x) + (1 − π1 )R(x) ≻ Q(x) ≻ π2 P(x) + (1 − π2 )R(x)
and π ∗ P(x) + (1 − π ∗ )R(x) ∼ Q(x)
A4 Independence: ∀P, Q, R ∈ P and ∀π ∈ [0, 1),
P(x) ≻ Q(x) ⇔ πP(x) + (1 − π)R(x) ≻ πQ(x) + (1 − π)R(x)
P(x) ∼ Q(x) ⇔ πP(x) + (1 − π)R(x) ∼ πQ(x) + (1 − π)R(x).
A5 State independence: If P(x) = Q(x), then P ∼ Q.

A1, A2, A3o → Advanced theorem of Ordinal Utility

A1, A2, A3c, A4, A5 → Expected Utility Theory (von Neumann Morgenstern
Utility)

4
Recap(2)

• Certainty equivalent c(x, η̃) and risk premia πsell (x, η̃) and πbuy (x, η̃):


E[u(x + η̃)] = u x + η̄ − πsell (x, η̃) ⇒ πsell (x, η̃) = η̄ − csell (x, η̃)
h
i
u(x) = E u x + η̃ − η̄ + πbuy (x, η̃) ⇒ πbuy (x, η̃) = η̄ − cbuy (x, η̃)

where η̄ = E[η̃].
−u ′′ (x) −xu ′′ (x)
• Risk aversion: ARA(x) ≡ u ′ (x)
, RRA(x) ≡ xARA(x) = u ′ (x)
.
• Arbitrage: An arbitrage opportunity is a portfolio with a nonpositive cost
and a nonnegative outcome in every state. At least one of the outcomes
or the cost must be nonzero.
• Complete market; a market is complete if all possible payoffs can be created.

• FTAP: two conditions are equivalent,

(i) There are no arbitrage opportunities.
(ii) There exists a positive linear pricing rule.

5
Structure of the Course
Lectures
• Week 1: From preferences to CAPM.
Axioms, Utility & Risk aversion, Complete Market, Arbitrage, CAPM.
Tutorial: Explain Referee Report, Problem set 1.

• Week 2: MV-analysis, CAPM, Empirical Tests of CAPM and alternative models.

Momentum, FF3, Double sorting/Fama Macbeth, Conditional CAPM, “fit”.
Tutorial: Explain Replication Assignment, Problem set 2.

• Week 3: EMH and Anomalies.

Excess volatility, Arbitrage opportunities, Predictability, Equity premium puzzle,
Bubbles, Limits to arbitrage.
Tutorial: Problem set 3.

• Week 4: Technical Analysis and Transaction Costs.

Tutorial: Problem set 4.

• Week 5: Parameter Uncertainty and Aggregating Investments.

Tutorial: Problem set 5.

• Week 6: Life-cycle investments and Guest Lecture by Robeco.

Tutorial: Problem set 6.

6
Overview of this week

What are we going to do?

1. Optimal portfolio selection

2. CAPM

3. Empirical performance of CAPM, alternatives?

Why do we do this?
• Fundamental theory to analyze investor choices.

• To understand empirical behavior of stock returns.

7
Readings

• Chapters 6 from John Ingersoll’s online book Financial Models and Theories.

• Fama, E. F.; French, K. R. (1992). The Cross-Section of Expected Stock Returns.

Journal of Finance 47 (2): 427- 465.

• Ferson, W. E., & Harvey, C. R. (1999). Conditioning variables and the cross
section of stock returns. Journal of Finance, 54(4), 1325-1360.

• Lewellen, J., & Nagel, S. (2006). The conditional CAPM does not explain asset-
pricing anomalies. Journal of Financial Economics, 82(2), 289-314.

• Jegadeesh, N., & Titman, S. (1993). Returns to buying winners and selling losers:
Implications for stock market efficiency. Journal of Finance, 48(1), 65-91.

• Carhart, M. M. (1997). On persistence in mutual fund performance. Journal of

Finance, 52(1), 57-82.

8
Mean-variance Analysis

9
Mean-Variance Analysis

Consider the quadratic utility function; u(W ) = W − 21 bW 2

Expected utility is
1 1
E[u(W̃ )] = E[W̃ − b W̃ 2 ] = E[W̃ ] − b(var(W̃ ) + (E[W̃ ])2 ) ≡ V (µ, σ 2 )
2 2

V (µ, σ 2 ) is a derived utility function, it is ordinal as expectation is already taken.

Two problems
−u ′′ (W ) b
(i) The Arrow-Pratt measure of risk aversion, ARA(W ) = u ′ (W )
= 1−bW
is
increasing in wealth, contrary to most evidence.
1
(ii) Risk aversion and marginal utility are only positive for outcomes less than Wmax ≡ b
Largest gross return; 1 + rmax ≡ Wmax /W0 = 1/(bW0 ).
An additional constraint, rewriting the above constraint on rmax gives;

−1 1 bW0
rmax = = = W0 ARA(W0 ) ≡ RRA(W0 )
(bW0 )−1 − 1 1 − bW0

such that for large rmax the relative risk aversion must be small.

10
Mean-Variance Analysis(2)

Two-parameter distributions
If all portfolio returns can be described with two parameters, we can probably(?) map
those into mean and variance.
⇒ we must assure that portfolio combinations of assets have returns that come from
the same distribution.
For example, if r˜ has a uniform distribution then w r˜1 + (1 − w )˜
r2 has a triangular
distribution if r˜1 and r˜2 are independent.

Normality: The portfolio adding up problem is solved if r˜ are multivariate normal because
the sum remains normal.
Actually, what we need is that the returns on all portfolios are completely characterized
by their mean and variance,
(i) All assets must have the same distribution.
(ii) The probability distribution must be characterized by µ and σ.
(iii) All portfolios must have the same distributions.

11
The Capital Asset Pricing Model (CAPM)

12
CAPM

Define the derived utility function;

Z∞
V (µw , σw ) = E[u(W0 (1 + w ′ r ))] = u(W0 (1 + µw + σw υ))g (υ)dυ
−∞
where υ is standard normal (also more general, elliptical distributions)

All investors like higher µ at a fixed σ:

∂
Z ∞
V1 (µw , σw ) ≡ V (µw , σw ) = W0 u ′ (W0 (1 + µw + σw υ))g (υ)dυ > 0
∂µw −∞

All investors dislike σ at a fixed µ:

Z ∞
∂
V2 (µw , σw ) ≡ V (µw , σw ) = υW0 u ′ (W0 (1 + µw + σw υ))g (υ)dυ
∂σw −∞
Z ∞
= υW0 [u ′ (W0 (1 + µw + σw υ)) − u ′ (W0 (1 + µw − σw υ))] g (υ) dυ < 0
0 | {z } | {z } | {z }
>0 <0 ≥0

using that g (υ) is symmetrical and u(.) is concave.

13
CAPM(2)
According to mean-variance utility:
All investors think about are only mean and variance and always higher means and lower
variances. So the set of efficient (in this case mean-variance efficient) portfolios is the
set that includes the highest mean at each possible level of variance.

The set of minimum-variance portfolios, those with the minimum variance for every
given mean return, µ̂, includes all the efficient plus maximally inefficient portfolios.

1 ′
min w Σw s.t.w ′ µ = µ̂
w 2
1 ′ ′ ′
L≡ w Σw + η[µ̂ − w µ] + γ(1 − 1 w )
2
∂L
0= = Σw − ηµ − γ1
∂w
If Σ is nonsingular, the min-var portfolio at
µ̂ is
−1
wµ̂ =ηµ̂ Σ µ + γµ̂ Σ−1 1 =
C µ̂ − A −1 B − Aµ̂ −1
Σ µ+ Σ 1
D D

where, A ≡ 1′ Σ−1 µ B ≡ µΣ−1 µ > 0 C ≡ 1′ Σ−1 1 > 0 D ≡ BC − A2 > 0

14
CAPM(3)

τ ≡ Σ−1 µ/(1′ Σ−1 µ), g ≡ Σ−1 1/(1′ Σ−1 1)

15
CAPM - with rf

If there is a risk-free asset, then the covariance matrix is singular.

The minimization problem can be restated in excess return form with the risk-
free asset eliminated.

The constraint is w ′ (µ − rf 1) = x

Portfolio weights are investments in the risky assets, so they need not sum to 1.
1′ w < 1 ⇒ the residual amount is invested in the risk-free asset
1′ w > 1 ⇒ the investor is borrowing to buy on margin.

16
CAPM - with rf (2)

1 ′
L≡ w Σw + λ[x − w ′ (µ − rf 1)]
2
∂L
0= = Σw − λ(µ − rf 1) ⇒ wx = λx Σ−1 (µ − rf 1)
∂w
Solving for constraint, wx (µ − rf 1) = x, determines λx = x/a and

x −1 xa Σ−1 (µ − rf 1)
wx = Σ (µ − rf 1) = t, where t≡ ,
b b a
a ≡ 1′ Σ−1 (µ − rf 1) = A − rf C
b ≡ (µ − rf 1)′ Σ−1 (µ − rf 1) = B − 2rf A + rf2 C

where A, B and C are as defined as before.

17
CAPM - with rf (3)
The tangency portfolio, t , is the portfolio in the solution whose weights sum to
1. As all portfolios have weights w ∝ Σ−1 (µ − rf 1),

Σ−1 (µ − rf 1)
t= (1)
1′ Σ−1 (µ − rf 1)

18
Sharpe Ratio

The tangency portfolio maximizes the Sharpe ratio — the ratio of mean excess
return to standard deviation
w ′ (µ − rf 1)
max S = (2)
w (w ′ Σw )1/2
⇒ only applies with a risk-free asset obviously.

Note that the portfolio constraint 1′ w = 1 is not required as S is homogeneous

of degree one in w .

FOC;
∂S (µ − rf 1) w ′ (µ − rf 1) (w ′ Σw )(µ − rf 1) − w ′ (µ − rf 1)Σw
0= = − Σ w =
∂w (w ′ Σw )1/2 (w ′ Σw )3/2 (w ′ Σw )3/2

19
Sharpe Ratio (2)

We don’t need to solve the FOC, only verify that t works


(w ′ Σw )(µ − rf 1) − w ′ (µ − rf 1)Σw 

??
0=
(w ′ Σw )3/2


w =t

The numerator (w Σw )(µ − rf 1) − w (µ − rf 1)Σw evaluated at w = t is

′ ′

(t ′ Σt )(µ − rf 1) − t ′ (µ − rf 1) − Σt (3)

Plugging in t , (3) is indeed equal to zero (check yourself!).

The maximized Sharpe ratio equals

µt − rf p
Smax = = (µ − rf 1)′ Σ−1 (µ − rf 1) (4)
σt

20
Pricing the CAPM

Define Ψw ≡ Σw as the N × 1 vector of covariances of the assets’ returns with

the portfolio w . For the tangency portfolio t = kΣ−1 (µ − rf 1) we have that,

Ψt = Σt = ΣkΣ−1 (µ − rf 1) = k(µ − rf 1), ⇒ (µ − rf 1) = k −1 Ψt

t ′ (µ − rf 1) = k −1 t ′ Ψt ,
⇒ µt − rf = k −1 σt2
µt − rf
⇒ (µ − rf 1) = Ψt
σt2
This is a mathematical tautology with no economic content. It is a property of
correlated random variables. It does not require normality.

21
Pricing the CAPM(2)

The economic content

(i) investors have homogeneous beliefs: same µ, Σ and same horizon.
(ii) all assets are infinitely divisible and can be traded without frictions (no
price impact, no transactions costs, no differential taxation, etc.)
(iii) Investors can borrow or lend unlimited amounts at the risk-free rate.
→ If this is true, all investors will want to hold the tangency portfolio levered.
So if an equilibrium exists, the tangency portfolio must be the market portfolio
(or more precisely the market portfolio of risky assets).

And,
µm − rf
µi − rf = σim 2
= βi (µm − rf ). (5)
σm

22
Testing the CAPM

23
Motivation

• We are trying to explain the cross section of asset returns.

• The CAPM explains the differences in average return through the betas
(= the sensitivity to the return of the market portfolio).

• However, the CAPM has not been empirically successful.

• So you may ask the question, why should we limit ourselves to explain
returns only through the market portfolio? Given the failure of the CAPM,
aren’t there other explanatory variables?

• Is it possible to construct a more general model to explain the cross section

of expected return, for instance a model that has the CAPM as a special
case?

24
CAPM

Classical approach: CAPM

The CAPM relation is used over time and in the cross-section.
Time series specification:

Ri,t+1 − Rf ,t = βi (RM,t+1 − Rf ,t )
Empirically we then regress for each asset i the excess return on a constant and
the market risk premium:

Ri,t+1 − Rf ,t = αi + βi (RM,t+1 − Rf ,t ) + εi,t+1

How to test the CAPM in time series?

1. αi = 0 for all i. Beta =1 voor een markt portfolio

2. Cross-sectional value-weighted mean of beta equals 1 (why?).

3. Additional explanatory factors should have an insignificant loading.

25
CAPM(2)

Cross-sectional specification:

Ri,t+1 − Rf ,t = λ0,t + λ1,t βi

where λ1,t is the estimated market risk premium in month t and βi is a result
from the time series regression.
Empirically we perform a regression of the excess returns on a constant and on
the β’s of the time series regression.
How to test the CAPM cross-sectionally?
1. λ0,t = 0
2. λ1,t = market risk premium in month t
3. βi should be the only factor driving cross-sectional differences in returns.
4. Fama-French challenge these predictions by a Fama-Macbeth analysis (basic
idea: size and beta are strongly correlated and once controlled for size, beta
has no cross-sectional explanatory power)

26
Empirical Observation (Cochrane, 2011)

Average excess returns rise from growth (low book-to-market, ”high price“) to
value (high book-to-market, ”low price“), but β doesn’t(!).
→ β doesn’t explain difference, we need a multi-factor model!
27
Fama & French (1992)

Ask the empirical question: is β related to expected returns?

→ using more data and more sophisticated tests than in Fama and Macbeth
(1973).

Idea: maybe β is priced because it is strongly correlated with the firm characteristic
Size.
Let’s separate the two effects: test if β is still priced in the cross-section after
controlling for Size.
Approach: form size-β sorted portfolios.

28
Separating effects

How we separate the effect of β from that of another possible explaining variable?

Two methods:

1. Sorting Method
Sort stocks in buckets based on company characteristics in previous period
and check return in this period.
→ no need to assume linear relation.

2. Fama-Macbeth Method
For each month run a cross-sectional regression with the returns of this
period as dependent variable and company characteristics in the previous
period as explanatory variables.

29
Method 1: Double Sorting (size example)

1. Sort stocks into size deciles.

2. Use data prior to size sorting data to estimate time series beta per stock
(take 2 to 5 years): so-called ”pre-ranking β’s“.
3. Within each size decile, sort stocks into β deciles → 100 size-β portfolios(!).
4. Calculate return of portfolio over next period (for instance, month or year)
(!) note: portfolio’s change each period, so to obtain portfolio’s returns,
need to redo 1-4 every time.
5. For each of the 100 size-β portfolios, estimate a portfolio β over the full
sample period: so-called ”post-ranking β’s“.

30
Method 1: Double Sorting (size example, 2)

31
Cross-sectional dispersion in β

• Cross-sectional variation in β’s across test assets is key, why?

• Let’s take the extreme, no cross-sectional spread in β. What happens?

• Hence: the more cross-sectional spread, the more power in the asset pricing
test.
1. Larger cross-sectional spread
2. Separate size-effect from β-effect

32
Sorting results

33
Sorting results(2)

34
Sorting results(3) - returns

35
Method 2: Fama-MacBeth regressions
The General Method
1. Run the time series regression for each firm, to obtain the β-estimate(s) of each
firm (alternative: rolling window),
e
Ri,t+1 = αi + βi (RM,t+1 − Rf ,t ) + ... + εi,t+1

2. Then, use the estimates to run a cross-sectional regression at each time (so for
100 datapoints, you run 100 seperate regressions!!).

e
Ri,t = λt βi + ... + αi,t
|{z}
errors

3. Final estimate of the factor risk premium (for instance, the market) is

T T
1 X 1 X
λ̂ = λt and, errors α̂i = αi,t
T t=1 T t=1

4. These are the estimates, what about the standard errors? (IID-case)

T T
1 X
2 1 X
2
σ 2 (λ̂) = 2
λ̂t − λ̂ and σ 2 (α̂i ) = 2
α̂i,t − α̂i .
T t=1 T t=1

36
Method 2: Fama-MacBeth regressions(2)

Fama and French (1992) use the following specification for the Fama-MacBeth
analysis:

Ri,t = α + γ1 βi,t−1 + γ2 ln(MEi,t−1 ) + γ3 ln(BE /MEi,t−1 ) + γ4 ln(A/MEi,t−1 )

+ γ5 ln(A/BEi,t−1 ) + γ6 (E /Pi,t−1 ) + ϵi,t

Take the average of the estimates γ’s (over the months).

This gives 300 sets of γ’s, average and standard deviation over these 300.

37
Fama-French (1992) findings

38
Summary of findings

1. Beta is insignificant, even if sole explanatory variable, why supported earlier?

2. Size and BTM have strong cross-sectional explanatory power (anomaly)

3. Including Size and BTM even absorbs existing anomalies (like earnings-to-
price)

CAPM is empirically not great...

39
The Fama French 3-factor model

40
Constructing the FF3-factor model
Fama and French (1993) propose the FF3-factor model as an alternative.

They add two additional factors or factor mimicking portfolios (Small Minus Big:
SMB, High Minus Low: HML).

Much debate whether these are really risk factors, or alternatively systematic
mispricing or data snooping.

How are the SMB and HML factor mimicking portfolios constructed?

SMB
• Sort all stock on their market capitalization (ME, or size) and split across
the median.
• Go long in the bottom half, go short in the top half.

HML
• Sort all stock on their book-to-market value (BE/ME) and split in three
parts (30/40/30)
• Go long in the top 30%, go short in the bottom 30%.

41
FF3-factor model

Traditional CAPM is given by;

Ri,t+1 − Rf ,t = αi + βi RMRFt+1 + εi,t+1

The FF3-factor model is given by

Ri,t+1 − Rf ,t = αi + β1,i RMRFt+1 + β2,i SMBt+1 + β3 HMLt+1 + εi,t+1

Fama and French:

If assets are priced rationally, our results suggest that stock risks are multidimensional.
One dimension of risk is proxied by size, ME. Another dimension of risk is proxied
by BE/ME, the ratio of the book value of common equity to its market value.

42
Testing the FF3-factor model

How to test the FF3-model?

• If the three factors capture all common variation in stock returns, the
intercept α should be zero.
• Time series test
• Using 25 portfolios: two-way sorts between 5 size and 5 B/M quintiles.

43
Results Fama and French (1996)

44
Implications of the FF3-model

What can we do with it?

1. Portfolio selection

2. Performance evaluation

3. Measuring abnormal returns in event studies

4. Calculation of cost of capital

45
Reaction to Fama French 3-factor model

46
Ferson & Harvey (1999)

Let’s assume the FF3-model is the true model

Similar to the CAPM, surprises in returns are only a function of surprise in (FF)
risk factors,
′
Ri,t+1 − E(Ri,t+1 ) = βi,t [Rp,t+1 − Et (Rp,t+1 )]
Assume the following general model for conditional expected returns and betas:
′
Et (Ri,t+1 ) = αi,t + βi,t E(Rp,t+1 )
′
βi,t = b0,i + b1,i Zt
′
αi,t = α0,i + α1,i Zt

47
What is different?

1. Multifactor model (CAPM nested in this version ↔ also tests of conditional

CAPM)

2. FF-factors assumed risk factors (rather than structural mispricing or characteristics)

3. Alphas and betas change over time (conditional model)

4. Alphas and betas assumed to be linear functions of economic state variables

(term spread, div-yield, credit spread, T-Bill rate).

5. Test assets are 25 Size-BTM portfolios (which have become the standard).

48
Conditional CAPM: Ferson & Harvey (1999)

What does the model look like if we substitute?

′ ′
Ri,t+1 = (α0,i + α1,i Zt ) + (b0,i + b1,i Zt )Rp,t+1

What are the testable implications?

1. Alpha should be zero and constant.
2. No other factor (than conditional beta) explains cross-sectional differences
in returns.

49
Ferson & Harvey (1999) tests

1. F -test tests if restricted (constant) beta specification fits the data better than
the more general time-varying beta specification.
2. Bonferroni tests jointly across portfolios
3. Table report R 2 ’s of the various models, also compare across panels
50
Ferson & Harvey (1999) tests(2)

Results are merely a copy of the original FF test (4 out of 25 significant) A more
stringent test is added: is alpha constant over time?
51
Ferson & Harvey (1999) findings

• Strong evidence of time variation in alphas and betas.

• Higher R 2 for conditional models, F-stat rejects H0 of loadings on macro-instruments

to be zero.

• Column 2 confirms FF-findings: unconditional alpha (in an unconditional beta

model) insignificantly different from zero.

• But conditional model outperforms an unconditional one.

• Columns 3 and 4: alphas are not constant → FF-factors do not explain conditional
expected returns.

52
Testing the 3-factor model cross-sectionally

Ferson and Harvey (1999) also address FF in a similar way as FF addressed the CAPM
→ perform a cross-sectional test, under the H0 of the three factor risk model.

What are the testable implications?

1. FF ”risk“ factors are the only factors explaining CS differences in returns
2. Constant in CS regression should be zero.

Ferson and Harvey (1999) add an additional out-of-sample factor (’fit’), measure fitted
expected return (α0,i + α′1,i Zt ; result of regressing Ri,t+1 on lagged variables Z .)

53
Ferson & Harvey (1999) findings(2)

54
Ferson & Harvey (1999) findings(3)

55
What is the effect of adding ’fit’ ?

1. Size insignificant in almost every specification.

2. BTM very often insignificant.

3. ’Fit‘ very significant (t-stat above 5.7).

4. Intercept often reduces after adding ’fit’.

5. Loading on the market beta increases after adding ’fit’.

56
So, is the CAPM (by itself) then really useless??

57
Lewellen and Nagel (2006)

• Can we save the CAPM in conditional form?

• Even if it does not hold in unconditional form, it might hold conditionally.

• Can we explain Size or BTM anomalies? (no..)

• Contrasting earlier work, Lewellen and Nagel (2006) focus on time series
alphas, rather than output from cross-sectional regressions.

• This is a pure time series analysis

58
Basic Idea

• Assume CAPM holds conditionally, what does this imply for unconditional
alphas and betas.
• Decompose unconditional alpha in three covariance terms (derivation follows):

γ2
 
γ h i γ
αU = 1 − 2 cov(βt , γt ) − 2 cov βt , (γt − γ)2 − 2 cov(βt , σt2 )
σM σM σM

• Plug in values for the three terms and compare the sum to anomaly alphas.

• Conclude that under reasonable values for RHS terms, conditional models
cannot explain anomalies.

What causes anomalies?

1. Covariation between β and the market risk premium (γt ).
2. Covariation between β and the conditional market variance (σt2 )
3. Second term (hard to interpret)

59
Steps in the derivation

What is our goal?

1. Express unconditional αU in (the above) covariance terms. (intuitively: is
the measurable time series variation in the three terms large enough to
justify an anomaly alpha?)
2. An expression for unconditional beta does the job (see few slides ahead)

3. Unconditional beta can be expressed as follows:

cov(Ri,t , RM,t )
βU = 2
σM

60
Conditional vs. unconditional CAPM

Let’s assume that the CAPM holds in conditional form:

e e
Ri,t+1 = βt RM,t+1 + εt+1
And let
βt = β + ηt
β = E[βt ], and E[ηt ] = 0
e e
The unconditional covariance between Ri,t+1 and RM,t+1 can there be expressed
as
e e e e
cov(Ri,t+1 , RM,t+1 ) = cov((β + ηt )RM,t+1 , RM,t+1 )

e
→ note that cov(RM,t+1 ,εt+1 ) equals zero by assumption.

61
Conditional vs. unconditional CAPM(2)

e e e
cov(Ri,t+1 , RM,t+1 ) = E[(β + ηt )(RM,t+1 )2 ] − E[(β + ηt )RM,t+1
e e
]E[RM,t+1 ]
2 e
= βσM + E[ηt (RM,t+1 )2 ] − E[ηt RM,t+1
e e
]E[RM,t+1 ]

We also know that,

e
Et−1 [RM,t ] = γt
e
Et−1 [(RM,t )2 ] = σt2 + γt2

2 
σt2 = Et−1 [(RM,te
)2 ]) − Et−1 [RM,t ]
E[RM,t+1 ] = γ

62
Conditional vs. unconditional CAPM(3)

We then rewrite:
e
E[ηt (RM,t+1 )2 ] = cov(ηt , γt2 + σt2 )
e
E[ηt RM,t+1 ]E[RM,t+1 ] = γcov(ηt , γt )

and therefore,
e e 2 e
cov(Ri,t+1 , RM,t+1 ) = βσM + E[ηt (RM,t+1 )2 ] − E[ηt RM,t+1
e e
]E[RM,t+1 ]
⇔
e e 2
cov(Ri,t+1 , RM,t+1 ) = βσM + cov(ηt , σt2 ) + cov(ηt , γt2 ) − γcov(ηt , γt )

Finally, write
γt = γ + (γt − γ)

and substitute in the second to last term to arrive at

e e 2
+ cov(ηt , σt2 ) + γcov(ηt , γt ) + cov ηt , (γt − γ)2


cov(Ri,t+1 , RM,t+1 ) = βσM

63
Conditional vs. unconditional CAPM (4)

Since βt ≡ β + ηt , we can replace ηt with βt and arrive at:

e e 2
+ cov(βt , σt2 ) + γcov(βt , γt ) + cov βt , (γt − γ)2


cov(Ri,t+1 , RM,t+1 ) = βσM

2
We divide by σM to get an expression for the unconditional beta:
γ 1 h i 1
β U = β + 2 cov(βt , γt ) + 2 cov βt , (γt − γ)2 + 2 cov(βt , σt2 )
σM σM σM
We further recall that
Et−1 [Ri,t ] = βγt
E[Ri,t+1 ] = βγ + cov(βt , γt )

64
Conditional vs. unconditional CAPM(5)

We define the unconditional alpha as

αU ≡ E[Ri,t+1 ] − β U γ
= γ(β − β U ) + cov(βt , γt )
γ2
 
γ γ
= 1 − 2 cov(βt , γt ) − 2 cov βt , (γt − γ)2 − 2 cov(βt , σt2 )
 
σM σM σM

Recall that we worked under the Null hypothesis that the conditional CAPM
holds.

If αU differs from zero (as is typically the case for Size-BTM portfolios), there
are three possible sources of beta covariation: γt , (γt − γ)2 or market volatility.

65
What is the basic idea?

Estimate anomaly alphas (e.g. for BTM and Mom portfolios)

Plug in values on the RHS of the equation for αU
Point out that reasonable values for RHS terms cannot explain the magnitude
of observed alphas
γ2
First, empirically 2
σM
is very small as well as (γt − γ)2 .

We therefore arrive at
γ2
 
γ γ
αU = 1 − 2 cov(βt , γt ) − 2 cov βt , (γt − γ)2 − 2 cov(βt , σt2 )
 
σM σM σM
γ
≈ cov(βt , γt ) − 2 cov(βt , σt2 )
σM
To explore the magnitude, consider the simplest case where βt only covaries with
the market risk premium (γt ), such that

αU ≈ ρσβ σγ

66
Lewellen and Nagel (2006) findings

We approximated α under the additional assumption that βt only covaries with

γt :
αU ≈ ρσβ σγ

Compare the empirical time series anomaly alphas of BTM (0.59%) and Mom
(1.01%) to implied theoretical alphas in Table 1.

67
Approach(2)

• Alternatively, Lewellen and Nagel (2006) estimate short window static

version of the CAPM.

• They use data of different frequencies (daily, weekly, monthly).

• And assume that parameters are constant within the window of observation
(quarterly, semi-annual, annual).

• Advantage: no need to specify conditioning variables.

68
Lewellen and Nagel (2006) findings(2)

Use time series variability to obtain standard errors.

69
Implications of Lewellen and Nagel (2006)

1. Conditional CAPM cannot explain BTM and Momentum effects.

2. If we assume that the CAPM holds theoretically, the size of the time series
pricing errors that we should observe is much smaller than what we actually
see in practice.

3. Plugging in all kinds of reasonable ranges of parameters does not bring us

close to the theoretically predicted time series CAPM pricing errors.

4. Nor does estimating time-varying alphas on various data frequencies.

70
 So, also conditional CAPM performs bad, but
empirically we find many factors, what is going on?

71
Lewellen, Nagel and Shanken(2010)

• Authors are worried that too many models explain the cross-section of
returns!

• Particularly strange since there is little overlap in economic sense.

• Lewellen, Nagel and Shanken(2010) ciritize methods employed by earlier

studies (particularly the cross-sectional R 2 of standard portfolio asset pricing
tests).

• They also provide recommendations to improve empirical tests

72
What is the problem?

• Traditionally: test assets are 25 Size-BTM portfolios.

• Run cross-sectional regression of excess returns on factors and evaluate

cross-sectional R 2 .

• Problem: 25 Size-BTM portfolios have strong factor structure (Size and

BTM explain 90% of time series variation and 80% of cross sectional
variation in returns).

• Any factor only weakly correlated with Size and BTM and uncorrelated
with idiosyncratic volatility does the job.

• Put differently: the confidence bound around the cross-sectional R 2 is huge.

73
Theoretical Observation

Suppose true model consists of K factors F :

Rt+1 = B Ft+1 + εt+1

(think of Rt+1 as 25 Size-BTM portfolio’s excess returns and Ft+1 as the FF3
factors)
• Propose to test this model with J factors P (assume for simplicity that
J = K)
• We also assume that:
1. F and P have a non-zero correlation (think of any small number).
2. P is uncorrelated with εt+1 .
• In that case, P perfectly explains the cross-section of expected returns
(even though it has little explanatory power for the time series)

74
Theoretical Observation (2)

• Suppose returns have a strict factor structure with respect F (var(εt+1 ) is

diagonal).

• Then any set of factors K perfectly explains the cross-section of expected

returns as long as the K assets are not asked to price themselves.
(that is, the K assets are not included on the left-hand side of the cross-
sectional regression and the risk premia are not require to equal their
expected returns)

• Lewellen, Nagel and Shanken (2010): We should hence demand much more
from AP models.

• For instance: a traded factor has a time series risk premium, which should
match λ when the factors K are included on the LHS.

75
Implications of Lewellen, Nagel and Shanken (2010)

1. Traditional tests provide a low hurdle for rejecting a model.

2. It is not a simple matter of getting the standard errors right.

3. Very easy to generate a high R 2 for cross-sectional regressions, especially

with more than one factor (even when factors are useless in economic
sense).

4. A sample cross-sectional R 2 of 50% may not significantly differ from zero.

76
Implications of Lewellen, Nagel and Shanken (2010) (2)

77
How to resolve?

1. Expand set of test portfolios (individual stocks, add portfolios, e.g. industry
portfolios to the cross-section to break strong factor structure).

2. Take the economic magnitude of the estimated market risk premium and cross-
sectional intercept seriously.

3. Use GLS instead of OLS (does not solve, but requires a higher hurdle).

4. If a factor is a traded portfolio, include it on the LHS of the cross-sectional

regression (test if CS loading equals TS risk premium).

5. Report confidence interval for the cross-sectional R 2 (might be hard to derive

analytically → simulations).

6. Report confidence intervals for the weighted sum of squared pricing errors (not
just show that they are insignificant by poor measurement, refers to both time
series and cross-sectional intercepts).

78
How to expand the set of test assets?

1. Use individual stocks (known problems).

2. Add industry portfolios (does not put any restrictions on price of risk, but
makes hurdle of R 2 higher because it breaks factor structure).

3. Compute for every test asset the beta w.r.t. traded risk factor and add
betas in second stage (what could be the problem here?, Note this is more
restrictive than just using it as explanatory variable on the RHS).

4. Add a traded factor on the LHS.

79
Example: Force the model to price liquidity risk

1. Compute for every portfolio the time series β with respect to the traded
liquidity factor.

2. Make liquidity-beta sorted portfolios (ensure dispersion) and add liquidity

betas of test assets on the RHS.

3. Test if the loadings on the liquidity beta equals the liquidity risk premium.

80
References

See course manual.

81