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1
Empirics of Financial Markets Empirics of Financial Markets
Patrick J. Kelly, Ph.D.
MICEX
1500
2000
2500
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x
L
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MICEX Levels
© 2011 Patrick J. Kelly 2
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In
d
e
MICEX returns
© 2011 Patrick J. Kelly 3
WHY?
MICEX + constituents: levels
© 2011 Patrick J. Kelly 5
MICEX + constituents: returns
© 2011 Patrick J. Kelly 6
11/3/2011
2
Asset Pricing Models in General
• Asset pricing models relate expected stock returns to
factors. Typically, these are written as linear models
(because easier than nonlinear):
• These linear models are an approximation of marginal
utility growth.
• This says: Discounted aggregate marginal utility growth
approximately follows some function of factors (f)
© 2011 Patrick J. Kelly 7
What Are Factors?
• These factors are proxies for marginal utility growth:
• Factors signal current (or forecast future) marginal
utility growth.
– What grows or stunts marginal utility?
• States of the economy: consider when the economy goes bad, put
extra value on assets/portfolios with high payoffs in these bad states
– Such portfolios will have high prices and low returns
– In some models factors can be those that forecast future
marginal utility growth, but they shouldn’t predict too well
(otherwise the models will predict larger than factual interest variation)
• This is why we use changes, not levels: returns, not prices
© 2011 Patrick J. Kelly 8
Asset Pricing Models:
Different ways to model marginal utility growth
• Capital Asset Pricing Model (CAPM)
– One factor
• Intertemporal CAPM (ICAPM)
– CAPM + 1 factor to capture changes in investment
opportunities
• Arbitrage Pricing Theory (APT)
– Multifactor
© 2011 Patrick J. Kelly 9
CAPM
• r
w
is the return to current wealth – NOT just the
market. Includes:
– Labor income
– Real estate
– Any private property
– All public property (parks, lakes, roads, bridges)
• One period model (ignores time)
© 2011 Patrick J. Kelly 10
The foundations of CAPM
• Sharpe, Lintner and Treynor (separately) grounded
asset pricing in a single market factor
– Because they created models of asset prices that built on the
intuition in Markowitz’s portfolio theory, which
simply notes that
• Investors do not (should not?) care about any one asset in their
portfolio of assets, but they should only care about the risk and
reward of the entire portfolio.
and demonstrates
• The power of diversification across many assets
© 2011 Patrick J. Kelly 11
This class
© 2011 Patrick J. Kelly 12
11/3/2011
3
Goal of Course
• Briefly introduce key theories in finance
– Mostly related to
• Asset pricing
• Market efficiency
• Learn the empirical tests of these theories Learn the empirical tests of these theories
• And what the data tell us about the theories
© 2011 Patrick J. Kelly 13
What we will cover
• Portfolio theory
– With liquidity and short sale constraints
• Asset Pricing
• Market Efficiency Market Efficiency
– Event studies
• Return predictability
– At long and short horizons
• Behavioral Finance
© 2011 Patrick J. Kelly 14
Syllabus
• 40% of class – 3 projects
– Find one partner
• Email me if you have problems pkelly@nes.ru
– I expect you know Gauss and Excel
• If you don’t, rethink taking this class
• 60% of grade final exam
– In English
– You will have at least one sample exam
• Few surprises
• Please pay attention to my.nes.ru!
© 2011 Patrick J. Kelly 15
Portfolio Selection
© 2011 Patrick J. Kelly 16
What’s next?
• We are going to run through about 1/4
th
to 1/3
rd
the
material I cover in a typical MBA Investments and
Portfolio Management class…
– in about 45 min to an hour.
• The point:
– To give you some of the basic intuition before you start
applying the reasoning to the data in your assignments
© 2011 Patrick J. Kelly 17
Portfolio Selection
• Marokowitz (1952)
– Prior belief: investors should solely maximize the discounted
value of cash flows
• Two assets with the same discounted cash flows are equally good
regardless of risk
– Proposes/Assumes the MeanVariance Criterion
• Investors care about both risk and return
– Shows that through diversification investors can get a
maximum return for a minimum of risk
© 2011 Patrick J. Kelly 18
11/3/2011
4
MeanVariance Criterion
• Investors prefer more to less and dislike risk
• From this, we can build a theory of investment choice based
on the expected (mean) return of an investment (higher =
better) and its risk as measured by the variance of returns
(lower = better)
– This is the meanvariance criterion.
– Critical assumption: the variance of returns is a good characterization
© 2008 Patrick J. Kelly 19 © 2008 Patrick J. Kelly 19
Critical assumption: the variance of returns is a good characterization
of the investment risk that investors care about
rr
s.d. s.d.
Mean Variance Criterion provides…
• Intuitive assessment of the relative merits of assets and
portfolios of assets
• Mean variance space is spanned by only two funds
(portfolios).
A i k f d ffi i i k f li – A risk free and an efficient risky portfolio
• Translates directly to investor Utility as a function of
portfolio return and variance
© 2008 Patrick J. Kelly 20
We can show our preferences (Utility)
E[r]
Q
S
Higher
Return
2
2
1
] [ o A r E U ÷ =
Indifference
Curve
© 2008 Patrick J. Kelly 21 © 2008 Patrick J. Kelly 21
σ
P
R
More
Risk
Critical Assumption
• Variance (Standard Deviation) is only characteristic of
risk important to us
• For example Skewness doesn’t matter…
© 2008 Patrick J. Kelly 22 © 2008 Patrick J. Kelly 22
Normal Distribution
© 2008 Patrick J. Kelly 23 © 2008 Patrick J. Kelly 23
rr
Symmetric distribution Symmetric distribution
s.d. s.d.
Skewed Distribution: Large Negative Returns Possible
© 2008 Patrick J. Kelly 24 © 2008 Patrick J. Kelly 24
rr
Negative Negative Positive Positive
Median
11/3/2011
5
Skewed Distribution: Large Positive Returns Possible
© 2008 Patrick J. Kelly 25 © 2008 Patrick J. Kelly 25
rr Negative Negative Positive Positive
Median
We will assume returns follow a Normal Distribution
© 2008 Patrick J. Kelly 26 © 2008 Patrick J. Kelly 26
rr
s.d. s.d.
M52: Investors care about the risk and return of their portfolio (of Many
Risky Assets)
• For a portfolio of N risky securities, variance is:
• The first term sums N variances; the second term
o
p
2
= w
i
2
var( i) + w
i
w
j
cov( i, j)
j =1
i = j
N
¿
i =1
N
¿
i =1
N
¿
© 2008 Patrick J. Kelly 27
;
captures Nx(N1) covariances.
• Diversification does not eliminate all risk.
Several Stocks
Yearly Returns for 5 Stocks
40.00%
60.00%
80.00%
100.00%
120.00%
GE
S.Cal.Edison
© 2008 Patrick J. Kelly 28 © 2008 Patrick J. Kelly 28
60.00%
40.00%
20.00%
0.00%
20.00%
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
Return
Y
e
a
r
McGrawHill
ConAgra
CitiGroup
Portfolio of Several Stocks
Yearly Returns for 5 Stocks
40.00%
60.00%
80.00%
100.00%
120.00%
GE
S.Cal.Edison
© 2008 Patrick J. Kelly 29 © 2008 Patrick J. Kelly 29
60.00%
40.00%
20.00%
0.00%
20.00%
1
9
8
6
1
9
8
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1
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8
1
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8
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2
0
0
0
2
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1
2
0
0
2
2
0
0
3
Return
Y
e
a
r
McGrawHill
ConAgra
CitiGroup
Returns and Standard Deviations
GE S.Cal.Edison McGrawHill ConAgra CitiGroup eqAvg
Mean 16.60% 8.11% 13.34% 12.97% 22.34% 16.17%
SD 26.27% 28.34% 18.89% 22.49% 37.72% 19.53%
© 2008 Patrick J. Kelly 30 © 2008 Patrick J. Kelly 30
r
f
=4%
Rewardto
risk 0.4796 0.1450 0.4944 0.3988 0.4862 0.6223
11/3/2011
6
• Possible to split investment funds between safe and
risky assets
• Risk free asset: proxy; Tbills
• Risky asset: stock (or a portfolio)
Controlling Risk: Allocating Between Risky & RiskFree Assets
© 2008 Patrick J. Kelly 31 © 2008 Patrick J. Kelly 31
• Ultimately we will see that under some assumptions
a riskfree asset and a particular risky portfolio span
the meanvariance return space.
Entire Stock Market vs. TBills
Entire Market Return vs. TBill Rates
10.00%
20.00%
30.00%
40.00%
50.00%
© 2008 Patrick J. Kelly 32 © 2008 Patrick J. Kelly 32
40.00%
30.00%
20.00%
10.00%
0.00%
19
58
19
60
19
62
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64
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66
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20
00
20
02
TBill Rate Entire Market
r
f
= 7% r
f
= 7%
o
rf
= 0% o
rf
= 0%
E[r
a
] = 15% E[r
a
] = 15% o
a
= 22% o
a
= 22%
Example
© 2008 Patrick J. Kelly 33 © 2008 Patrick J. Kelly 33
aa
w = % in a w = % in a (1w) = % in r
f
(1w) = % in r
f
E[r
p
] = wE[r
a
] + (1  w)r
f
E[r
p
] = wE[r
a
] + (1  w)r
f
r
p
= combined portfolio r
p
= combined portfolio
For example, w = .75 For example, w = .75
Expected Returns for Combinations
© 2008 Patrick J. Kelly 34 © 2008 Patrick J. Kelly 34
E[r
p
] = .75(.15) + .25(.07) = .13 or 13% E[r
p
] = .75(.15) + .25(.07) = .13 or 13%
o
p
= .75(.22) + .25(0) = .165 or 16.5% o
p
= .75(.22) + .25(0) = .165 or 16.5%
What Return for What Risk?
E[r] E[r]
E[r E[r
aa
] = 15% ] = 15%
aa
CAL CAL
(Capital (Capital
Allocation Allocation
Line) Line)
© 2008 Patrick J. Kelly 35 © 2008 Patrick J. Kelly 35
rr
ff
= 7% = 7%
22% 22%
00
ff
) S = 8/22 ) S = 8/22
E[r E[r
aa
] ]   rr
ff
= 8% = 8%
o
E[r E[r
pp
] = 13% ] = 13%
16.5% 16.5%
Extending the CAL
E(r)
E(r E(r
pp
) = 15% ) = 15%
aa
© 2008 Patrick J. Kelly 36 © 2008 Patrick J. Kelly 36
rr
ff
= 7% = 7%
22% 22%
00
FF
) S = 8/22 ) S = 8/22
E(r E(r
pp
) )   rr
ff
= 8% = 8%
o
11/3/2011
7
The Capital Allocation Line
• CAL depicts the possible asset allocations, i.e. risk
return combinations
• Slope S of CAL =
– Measures the increase in expected return an investor obtains
f t ki dditi l it f t d d d i ti i k
( )
( )
364 . 0
22
8
22
7 15
= =
÷
=
÷
=
P
F P
r
r r E
S
o
© 2008 Patrick J. Kelly 37 © 2008 Patrick J. Kelly 37
for taking on one additional unit of standard deviation risk
– Also called the
– “rewardtovariability” ratio
– Sharpe Ratio
Extending the CAL
• The portfolio has the most risk if all monies are
invested in a (w=1)
• Q: How can we assume even more risk?
• A: Since risk increases linearly in w, we need to increase
w > 1 (borrow money to invest in a)
B i h i k f i il bl f
© 2008 Patrick J. Kelly 38 © 2008 Patrick J. Kelly 38
– Borrowing at the riskfree rate is not available for
individual investors, need to borrow at a rate r
B
> r
F
CAL with Borrowing
E(r)
E(r E(r
pp
) = 15% ) = 15%
aa
© 2008 Patrick J. Kelly 39 © 2008 Patrick J. Kelly 39
rr
ff
= 7% = 7%
22% 22%
00
FF
) S = 8/22 ) S = 8/22
E(r E(r
pp
) )   rr
ff
= 8% = 8%
o
Is there an optimal portfolio choice?
E(r) E(r)
E(r E(r
pp
) = 15% ) = 15%
aa
CAL CAL
(Capital (Capital
Allocation Allocation
Line) Line)
© 2008 Patrick J. Kelly 40 © 2008 Patrick J. Kelly 40
rr
ff
= 7% = 7%
22% 22%
00
FF
) S = 8/22 ) S = 8/22
E(r E(r
pp
) )   rr
ff
= 8% = 8%
o
Portfolio Example
• Consider an example where we can invest into risky
assets (stocks, funds) 1 and 2.
• Asset 1: E(r
1
) = 10% σ
1
= 12%
• Asset 2: E(r
2
) = 17% σ
2
= 25%
© 2008 Patrick J. Kelly 41
• What is the expected portfolio return and standard
deviation?
Benefits from Diversification
     
2 2 1 1
r E w r E w r E
p
+ =
2 , 1 2 1 2 1
2
2
2
2
2
1
2
1
2 w w µ o o o o o w w
p
+ + =
Asset 1: E(r
1
) = 10% σ
1
= 12%
Asset 2: E(r
2
) = 17% σ
2
= 25%
© 2008 Patrick J. Kelly 42
Portfolio Standard Deviation (%) for Given Correlation
Weight in 1 E(r) portf. ρ1,2 =  1 ρ1,2 = 0 ρ1,2 = 0.2 ρ1,2 = 0.5 ρ1,2 = 1
0
0.2
0.4
0.6
0.8
1
Portfolio Standard Deviation (%) for Given Correlation
Weight in 1 E(r) portf. ρ1,2 =  1 ρ1,2 = 0 ρ1,2 = 0.2 ρ1,2 = 0.5 ρ1,2 = 1
0 17.0 25.0 25.0 25.0 25.0 25.0
0.2 15.6 17.6 20.1 20.6 21.3 22.4
0.4 14.2 10.2 15.7 16.6 17.9 19.8
0.6 12.8 2.8 12.3 13.4 15.0 17.2
0.8 11.4 4.6 10.8 11.7 12.9 14.6
1 10.0 12.0 12.0 12.0 12.0 12.0
The lower the correlation the
lower the portfolio variance
Even though the
expected return
is the same
11/3/2011
8
How does risk reduction depend on µ?
Asset 1: E(r
1
) = 10% σ
1
= 12%
Asset 2: E(r
2
) = 17% σ
2
= 25%
© 2008 Patrick J. Kelly 43
Portfolios of More the Two Risky Assets
• We are looking for the lowest variance portfolio for a
given return
MIN o
p
2
= w
i
2
var(r
i
) + w
i
w
j
cov(r
i
, r
j
)
j=1
i=j
N
¿
i=1
N
¿
i=1
N
¿
© 2008 Patrick J. Kelly 44
j
subject to : E[r
p
] = a given return
and w
i
i=1
N
¿
=1
Portfolios of More the Two Risky Assets
• We are looking for the lowest variance portfolio for a
given return
2
1
2
E ' = o w w MIN
p
© 2008 Patrick J. Kelly 45
1 and
:
= '
= '
i
µ
w
E w to subject
0 and > w
with shortsale constraints
Efficient Tradeoff Line & Efficent Frontier Curve
15%
20%
25%
R
e
t
u
r
n
What Happens When We Add More Assets?
Efficient Tradeoff Line & Efficent Frontier Curve
15%
20%
25%
R
e
t
u
r
n
B
2
© 2008 Patrick J. Kelly 46
0%
5%
10%
0% 5% 10% 15% 20% 25% 30%
Standard Deviation
E
x
p
e
c
t
e
d
0%
5%
10%
0% 5% 10% 15% 20% 25% 30%
Standard Deviation
E
x
p
e
c
t
e
d
R
A
1
Efficient Tradeoff Line & Efficent Frontier Curve
15%
20%
25%
R
e
t
u
r
n
There is a unique optimal portfolio
MMarket
© 2008 Patrick J. Kelly 47
0%
5%
10%
0% 5% 10% 15% 20% 25% 30%
Standard Deviation
E
x
p
e
c
t
e
d
R
Efficient Tradeoff Line & Efficent Frontier Curve
15%
20%
25%
R
e
t
u
r
n
There is a unique optimal portfolio
MMarket
Systematic/Covariance Risk Idiosyncratic Risk (n
i
)
© 2008 Patrick J. Kelly 48
0%
5%
10%
0% 5% 10% 15% 20% 25% 30%
Standard Deviation
E
x
p
e
c
t
e
d
R
11/3/2011
9
How can we tell…?
• How can we tell if adding more assets improves the
efficient frontier?
– Mathematically adding any less than perfectly correlated
security ought to improve the exante efficient frontier
– Improvement may not be meaningful…
• The problem is that the exante efficient frontier will
always lie within the expost efficient frontier.
– Simply due to luck? consider…
© 2011 Patrick J. Kelly 49
Testing Portfolio Efficiency
• Consider the question whether a certain portfolio 1 is
still efficient if one makes available additional assets (2,
3 and 4)
– If Expected returns and covariances were known, then easy
• If you cannot form a portfolio with higher mean and/or lower
variance by including assets 2, 3, and 4 then 1 still efficient
• Problem:
– With a probably of 1, the true exante efficient portfolio is
within the empirically observed efficient portfolio.
– To illustrate the problem, consider….
© 2011 Patrick J. Kelly 50
Illustration (Sentana, 2009)
• Suppose assets/funds 1, 2, 3 and 4 all have E[rr
f
]=0
and Cov(i,j) =0 for all
• In truth, adding assets 2, 3 and 4 will not improve the
reward for risk and will not change the efficient
tf li portfolio.
• The next chart simulates two years of daily returns and
plots the efficient frontiers from these simulations
where the TRUE exante Sharpe ratio is ZERO.
© 2011 Patrick J. Kelly 51
Simulated Efficient Frontiers (Sentana, 2009)
© 2011 Patrick J. Kelly 52
Sampling Distribution of the GMM estimator
© 2011 Patrick J. Kelly 53
true
Mean of
Simulated
The point
• The sampling error is large when using sample means,
variances and covariances to estimate expected means
and variances, but
• Statistical tests are well suited to the problem
© 2011 Patrick J. Kelly 54
11/3/2011
10
Intuition: Tests of Mean Variance Efficiency
• Cochrane (2001, Chapters 2 and 5) shows that any
expected return can be related to any meanvariance
efficient portfolio lying on the efficient frontier:
E r
i
( )
= r
f
+ 
i,mv
E r
mv
( )
÷r
f
¸
(
¸
• This structure suggests a natural test for efficiency:
• Test whether α is nonzero.
– This is the basic intuition of most tests of portfolio efficiency
• Differences across tests are mostly econometric refinements
© 2011 Patrick J. Kelly 55
E r
i
( )
÷r
f
=o + 
i,mv
E r
mv
( )
÷r
f
¸
(
¸
Test of Mean Variance Efficiency
• Gibbons, Ross, Shenken (1989)
T ÷ N ÷1
N
1+
E
T
f
( )
ˆ o f
( )

\

.


2
¸
(
¸
(
(
÷1
ˆ' o
ˆ
E
÷1
ˆ o ~ F
N,T÷N÷1
– Where f is a return based factor or portfolio return on the
meanvariance 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, αis a vector of the intercepts from the
N testasset regressions, and Σ is the cross test asset residual
covariance matrix, such that
© 2011 Patrick J. Kelly 56
E c
t
' c
t
 
= E
Mean of
Refinements
• The GRS test is reasonably robust to small departures
from normality of the return distribution
• MacKinlay and Richardson (1991, Journal of Finance)
propose refinements to deal with leptokurtosis in
returns in a GMM framework.
• Hodgson, Linton, and Vorkink (2002, Journal of Applied
Econometrics) derive semiparametric tests that posses
more power to reject the null.
• See Sentana (2009, Econometrics Journal) for a discussion
of further refinements
© 2011 Patrick J. Kelly 57
Testing whether a portfolio is meanvariance efficient
Useful for:
• Mutual Fund performance evaluation
• Measuring gains from portfolio diversification
• Tests of linear asset pricing models
Not trivial because:
• Realized returns are not the same as expected returns
*Ideas borrowed from Sentana (2009)
Homework 1
Discussion of
• Liquidity and its definitions
• Finding the efficient frontier and the optimal portfolio g
– @Risk and VaR analyses
– Bootstrapping
© 2011 Patrick J. Kelly 59
A prelude p
11/3/2011
11
Last Time: a Steeper CAL is better
E(r) E(r)
E(r E(r
pp
) = 15% ) = 15%
aa
CAL CAL
(Capital (Capital
Allocation Allocation
Line) Line)
© 2008 Patrick J. Kelly 61
rr
ff
= 7% = 7%
22% 22%
00
ff
o
S = 0.36 S = 0.36
S = 0.72 S = 0.72
Risk in EquallyWeighted Portfolios
Avg. Std. Dev. 30%
Avg. Correlation 0.2
# of Assets Portfolio Due to Due to
Std. Dev. Variances Covariances
© 2008 Patrick J. Kelly 62 © 2008 Patrick J. Kelly 62
Std. Dev. Variances Covariances
2 23.24% 83.33% 16.67%
3 20.49% 71.43% 28.57%
4 18.97% 62.50% 37.50%
100 13.68% 4.81% 95.19%
1000 13.44% 0.50% 99.50%
10000 13.42% 0.05% 99.95%
How Can We Raise the CAL?
• Raise Return
( )
( )
P
F P
r
r r E
S
o
÷
=
© 2008 Patrick J. Kelly 63
• Lower risk
Diversify with Risky Assets
Efficient Tradeoff Line & Efficent Frontier Curve
15%
20%
25%
R
e
t
u
r
n
What Happens When We Add More Assets?
Efficient Tradeoff Line & Efficent Frontier Curve
15%
20%
25%
R
e
t
u
r
n
B
2
© 2008 Patrick J. Kelly 64
0%
5%
10%
0% 5% 10% 15% 20% 25% 30%
Standard Deviation
E
x
p
e
c
t
e
d
0%
5%
10%
0% 5% 10% 15% 20% 25% 30%
Standard Deviation
E
x
p
e
c
t
e
d
R
A
1
Efficient Tradeoff Line & Efficent Frontier Curve
15%
20%
25%
R
e
t
u
r
n
Which portfolio does everyone choose?
MMarket
© 2008 Patrick J. Kelly 65
0%
5%
10%
0% 5% 10% 15% 20% 25% 30%
Standard Deviation
E
x
p
e
c
t
e
d
R
Optimal Decision Rule
If everyone prefers more return to more risk and everyone
sees the same assets there is only one best risky
portfolio. Meaning:
• Optimal Portfolio Selection takes 2 steps:
• 1. Choose Optimal Risky Portfolio
© 2008 Patrick J. Kelly 66
• 2. Optimal Allocation between Risky and Riskless
• This is called the Separation Property
• Notice this means:
– All rational riskaverse investors will passively index holdings
to some risky fund and account for risk aversion by keeping
some money totally safe
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12
Asset Pricing Implications
• If everyone chooses the same portfolio (by the
separation property), how do we value an individual
stock?
– Does its return matter?
– Does its standard deviation matter?
© 2008 Patrick J. Kelly 67
Many Risky Assets
• For a portfolio of N risky securities, variance is:
• The first term sums N variances; the second term
o
p
2
= w
i
2
var( i) + w
i
w
j
cov( i, j)
j =1
i = j
N
¿
i =1
N
¿
i =1
N
¿
© 2008 Patrick J. Kelly 68
;
captures Nx(N1) covariances.
• As N gets large, which of the two dominates?
– The variances are “overwhelmed”….
– Nx(N1) gets much larger than N
What if... ?
• If there were enough assets to diversify
away all firmspecific risk, would you want
to hold any?
© 2008 Patrick J. Kelly 69
• Why?
Rational investors and diversified portfolio
• If you are able to complete diversify away firm specific
risk, you will
• Because no one will be willing to pay you anything for
taking that risk….
© 2008 Patrick J. Kelly 70
Capital Asset Pricing Model
• William Sharpe & John Lintner (1964) insight was that
we should only care about how a stock comoves with
the rest of the market – because the firmspecific
variance can be diversified away.
© 2008 Patrick J. Kelly 71
Assumptions of the CAPM
1. Perfect competition: Markets are large and investors are
price takers
2. Frictionless markets: no taxes and no transactions costs
3. Complete markets: All risky assets are publically traded
4. Unlimited borrowing and lending at the riskfree rate (or
unlimited shorting)
5. Homogenous expectations: Everyone sees the same
efficient frontier, because everyone holds the same
beliefs about expect returns and variances
6. Investors follow the meanvariance criterion and have an
identical one holding period over which the mean
variance criterion is applied (utility is maximized)
© 2008 Patrick J. Kelly 72
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13
From Assumptions to CAPM
1. Raise the capital allocation line
– Mean variance criterion
2. Maximum diversification
– Frictionless markets
3. Investors choose the same optimal portfolio
– Homogeneous expectations, perfect competition, complete
markets, and unlimited borrowing and lending at the risk
free rate
4. Only systematic (market) risk is important
– Only covariance risk matters
– Only one price of risk
© 2008 Patrick J. Kelly 73
Efficient Tradeoff Line & Efficent Frontier Curve
20%
25%
n
Capital Market Line (CML)
MMarket
CML
© 2008 Patrick J. Kelly 74
0%
5%
10%
15%
0% 5% 10% 15% 20% 25% 30%
Standard Deviation
E
x
p
e
c
t
e
d
R
e
t
u
r
MMarket
M
f M
r r E
o
÷ ) (
Measuring Systematic Risk
• Could use cov(E[r
stock
], E[r
market
]) …
BUT:
– again, the units are a pain with cov(). Correlation, then?
– No; what is the correlation between 2 systematic risks?
– Doesn’t account for how much it moves when correlated
• We need a measure of a stock’s systematic risk only.
This is beta () which is unitless:
© 2008 Patrick J. Kelly 75
This is beta (), which is unitless:
• Why it isn’t this:
– Actually, numerically identical
) ] [ var(
) ] [ , ] [ cov(
f m
f m f i
i
r r E
r r E r r E
÷
÷ ÷
= 
]) [ var(
]) [ ], [ cov(
m
m i
i
r E
r E r E
= 
Reward for risk
• Reward for no systematic risk (β=0)
r
f
• Reward for investing in the market portfolio (β=1)
E[r
m
]r
f
• Reward for investing in any asset:
© 2008 Patrick J. Kelly 76
( )
f m i f i
r r E r r E ÷ = ÷ ] [ ] [ 
Asset Pricing Models in General
• Asset pricing models relate expected stock returns to
factors. Typically, these are written as linear models
(because easier than nonlinear):
• These linear models are an approximation of marginal
utility growth.
• This says: Discounted aggregate marginal utility growth
approximately follows some function of factors (f)
© 2011 Patrick J. Kelly 77
What Are Factors?
• These factors are proxies for marginal utility growth:
• Factors signal current (or forecast future) marginal
utility growth.
– What grows or stunts marginal utility?
• States of the economy: consider when the economy goes bad, put
extra value on assets/portfolios with high payoffs in these bad states
– Such portfolios will have high prices and low returns
– In some models factors can be those that forecast future
marginal utility growth, but they shouldn’t predict too well
(otherwise the models will predict larger than factual interest variation)
• This is why we use changes, not levels: returns, not prices
© 2011 Patrick J. Kelly 78
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Asset Pricing Models:
Different ways to model marginal utility growth
• Capital Asset Pricing Model (CAPM)
– One factor
• Intertemporal CAPM (ICAPM)
– CAPM + 1 factor to capture changes in investment
opportunities
• Arbitrage Pricing Theory (APT)
– Multifactor
© 2011 Patrick J. Kelly 79
CAPM
• r
w
is the return to current wealth – NOT just the
market. Includes:
– Labor income
– Real estate
– Any private property
– All public property (parks, lakes, roads, bridges)
• One period model (ignores time)
© 2011 Patrick J. Kelly 80
Merton’s (1973) ICAPM
• Multiperiod version of CAPM
– Factors are “state variables” that determine how well the
investor can do his/her optimization. A factor that can be
anything that affects
• t lth • current wealth
• the distribution of distribution of future returns
– Labor market income, Housing value, Small business
• Changes in the investment opportunity set.
– Investors with long horizons are unhappy with news that future returns
are lower
» High value to assets which are negatively correlated with long term
wealth. That is, prefer stocks with high payouts during recessions
– Anything that affects the average investor
© 2011 Patrick J. Kelly 81
Note about the extra ICAPM factor
• The ICAPM state variable(s) should affect the average
investor.
– Consider a risk that in the future makes A better off and B
worse off
• B sells the risk
• A buys it
– Net effect is zero.
• This helps explains why LOTS of variables are
correlated with returns, but do not carry any priced risk
– For example: Industry returns comove, but not once you
control for priced risks.
© 2011 Patrick J. Kelly 82
APT
• Using the Law of One Price
• Common comovements of stock returns should have
the same price
– Complete idiosyncratic price movements are not priced
– If well diversified only common factors affect consumption
I t iti i th p i bit pl – Intuition is the same as previous arbitrage example
– No restrictive assumptions about returns or preferences
• APT does not suggest factors. It says start statistical
– Find comovement in stock returns
• ICAPM says start with theory when looking for factors
– Variables that affect the distribution of returns
© 2011 Patrick J. Kelly 83
Weaknesses of CAPM and ICAPM
• CAPM is linear and does not price nonnormally
distributed returns well
– Should price derivatives, but generally cannot, their returns
are too nonnormal
• Why linear?
• Identity of “state” variables (f ) unknown • Identity of state variables (f
s
) unknown
– But, they should forecast something about the economy
• Portfolio of wealth is unobservable
– It includes are return generating assets (including human
capital and public property)
– Transactions costs and illiquidity can delink consumption and
returns at high frequencies
© 2011 Patrick J. Kelly 84
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Roll’s Critique (1977)
• If a portfolio against which returns are measured is ex
post efficient, then no security will have abnormal
returns
• If the portfolio is inefficient then any abnormal return
is possible
If alpha is non zero is it because the market portfolio is – If alpha is nonzero is it because the market portfolio is
inefficient or is it because there is mispricing?
• If returns are linear in Beta, all that proves is that the
market is expost efficient
– If they are not linear in beta you do not know if it is because
the market is
• expost inefficient or because
• there is a missing factor
© 2011 Patrick J. Kelly 85
Roll’s Critique (1977) continued
• Only true test if the true market portfolio is expost
efficient
• True market portfolios is unobservable. So, good luck.
© 2011 Patrick J. Kelly 86
Testing CAPM
d O h A P i i M d l and Other Asset Pricing Models
© 2011 Patrick J. Kelly 87
The Market Model
• Alphas and betas are measured statistically using
historical returns on the security and the market
portfolio proxy, e.g. S&P 500
• Run the regression of the Market Model:
 ] [
© 2008 Patrick J. Kelly 88
• Apply this to a particular stock, and you get a Security
Characteristic Line...
it ft mt i i ft it
r r r r c  o + ÷ + = ÷ ] [
Security Characteristic Line
Equation of Line:
) (
ˆ
ˆ
f m f i
r r r r ÷ + = ÷  o
40%
50%
60%
P
r
e
m
i
u
m
ε
it ft mt i i ft it
r r r r c  o + ÷ + = ÷ ] [
© 2008 Patrick J. Kelly 89
Beta=Slope
Alpha=Intercept
20%
10%
0%
10%
20%
30%
15% 10% 5% 0% 5% 10% 15% 20% 25% 30% 35%
Market Risk Premium
S
t
o
c
k
R
i
s
k
P
How to Calculate Beta
• Returns are for what period?
– Best is annual or quarterly – but too few observations
– Practice is to use monthly
– Make sure that all returns are stated monthly
it ft mt i i ft it
r r r r c  o + ÷ + = ÷ ] [
© 2008 Patrick J. Kelly 90
• Pay attention to the risk free rate, because that is usually stated yearly
• Use portfolios to reduce estimation error
– Run a CAPM type regression on each stock
– Sort stocks into Beta portfolios
– Calculate portfolio Betas
– Attribute portfolio Betas to each stock
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Calculating Google’s Beta for real
© 2008 Patrick J. Kelly 91
Calculating Google’s Beta for real 2
© 2008 Patrick J. Kelly 92
Calculating Google’s Beta for real 3
© 2008 Patrick J. Kelly 93
Calculating Google’s Beta for real 4
© 2008 Patrick J. Kelly 94
Calculating Google’s Beta for real 5
© 2008 Patrick J. Kelly 95
Predicting Betas
• The Beta we just calculated is based on historic data
• We need a future beta.
• Betas tend to mean revert.
© 2008 Patrick J. Kelly 96
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Mean Reversion as Seen with IBM’s Betas
• When Beta is below the mean (typically 1) betas tend to
rise.
• When Beta is above then mean betas tend to fall
© 2008 Patrick J. Kelly 97
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 98
1
3
1
3
2
× + × = ta HistoricBe Beta Adjusted
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
than the risk free return
– In general, riskier stocks should earn higher return on average
• Market portfolio is meanvariance efficient
• If you crosssectionally regress β on risk premia,
estimates should equal the average market risk premium
(λ)
© 2011 Patrick J. Kelly 99
FamaMcBeth (1973)
• Tests if high beta is associated with high returns and
vice versa.
• General format:
– Timeseries regressions to get betas for test portfolios
• Usually beta sorted porttflios
– Monthly crosssectional regressions to test if high beta is – Monthly crosssectional regressions to test if high beta is
associated with high return
• Cochrane (1999) shows that GMM panel regressions
are identical under some assumptions
© 2011 Patrick J. Kelly 100
General FM73 Algorithm
• Use monthly data from years 1 through 7 to estimate CAPM Beta
17
for each
company.
• Use to rank stocks (rank
17
) into 20 equally sized groups (call portfolios
formed on rank
17
portfolio
17
)
• Use monthly data from years 8 through 12 to estimate CAPM Beta
812
(= ) for
each company.
• Find the average Beta
812
and average (equally weighted) return for each
Portfolio in each month of year 13 (i e letting delisted companies to drop Portfolio
17
in each month of year 13 (i.e. letting delisted companies to drop
out each month).
• Roll one year forward and repeat steps 14 till done.
– Example in step 1 use data from years 2 through 8
• For each month run a crosssectional regression using the average Betas and
returns calculated in step 4.
• Collect the time series of the coefficients (λ’s)
© 2011 Patrick J. Kelly 101
Example from FF92
• They look at whether CAPM works.
– It doesn’t.
• Here is what they do:
– The sort stocks by size and by the stock’s preranking beta.
P ki b b l l d f h k h 5 f • Preranking betas: betas are calculated for each stock over the 5 years of
monthly data preceding (not including) the current year (from t5 to t
1).
• Stocks are sorted by size and then each size portfolio is sorted by the
preranking beta.
• For each month in year t, calculate equally weighted portfolio returns
• For each size/prerankingbeta portfolio calculate Beta for the entire
sample, including one lag of the value weighted market to correct for
nonsynchronous trading.
• Assign the betas to each stock in the portfolio and run monthly cross
sectional regressions.
© 2011 Patrick J. Kelly 102
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Average Slopes (tStatistics) from MonthbyMonth Regressions of Stock Returns on
,B,Size, BooktoMarket Equity, Leverage, and E/P: July 1963 to December 1990
© 2011 Patrick J. Kelly 103
Related findings Fama French 1992  Size and Beta
© 2011 Patrick J. Kelly 104
Size and Book to Market
© 2011 Patrick J. Kelly 105