6. Empirical Evidence

Question 1

What does CAPM stand for?

Answer 1

Capital Asset Pricing Model.

Question 2

What is the formula for beta in CAPM?

Answer 2

βi = Cov(ri, rM) / σ²M.

Question 3

What is the security market line (SML)?

Answer 3

A graphical representation of the expected return of a security as a function of its beta.

Question 4

What are the three factors in the Fama-French 3-factor model?

Answer 4

Market risk (RM), size (SMB), and value (HML).

Question 5

What is the purpose of the Fama-MacBeth regression?

Answer 5

To estimate the reward for bearing systematic risk and test CAPM validity.

Question 6

How does CAPM explain the relationship between risk and return?

Answer 6

CAPM states that the expected return of an asset is proportional to its beta, which measures its systematic risk relative to the market.

Question 7

Why is beta important in asset pricing?

Answer 7

Beta measures a security’s sensitivity to market movements and helps determine its risk premium in CAPM.

Question 8

How do Fama and French extend CAPM in their 3-factor model?

Answer 8

They add size (SMB) and value (HML) factors to market risk (RM) to capture additional sources of return variation.

Question 9

What is the implication of Roll’s critique for CAPM tests?

Answer 9

Roll argues that the true market portfolio is unobservable, making empirical tests of CAPM dependent on a proxy for the market.

Question 10

What does the momentum factor (WML) represent in asset pricing?

Answer 10

It captures the return difference between stocks with high past returns (winners) and low past returns (losers).

Question 11

Explain how measurement error in beta affects CAPM tests.

Answer 11

Measurement error in beta introduces noise, leading to biased and inconsistent estimators, weakening the reliability of CAPM tests.

Question 12

How does the Fama-MacBeth methodology address cross-sectional return variation?

Answer 12

It separates beta estimation (first-pass regression) from testing risk-return relationships (second-pass regression) to evaluate systematic risk premiums over time.

Question 13

Discuss the risk-based interpretation of the Fama-French 3-factor model.

Answer 13

The model suggests that SMB and HML capture additional dimensions of systematic risk related to small-cap stocks and high book-to-market ratios, rewarding investors for bearing these risks.

Question 14

Why is the illiquidity factor significant in asset pricing models?

Answer 14

Illiquidity affects trading costs, price concessions, and investor behavior, influencing expected returns, as shown in Pastor-Stambaugh’s illiquidity factor.

Question 15

Compare the CAPM and Fama-French models in explaining asset returns.

Answer 15

While CAPM uses only beta and market risk, the Fama-French model includes size (SMB) and value (HML) factors, providing better explanatory power for returns, especially for small-cap and value stocks.

Question 16

Analyze how macro factor models incorporate economic variables into asset pricing.

Answer 16

Macro factor models use systematic economic variables like GDP growth, inflation, and bond risk premiums as factors to explain asset returns, reflecting how economic changes affect investment performance.

Question 17

Evaluate the implications of Roll’s critique for the practical application of CAPM.

Answer 17

Roll’s critique highlights the challenge of identifying the true market portfolio, suggesting that CAPM tests rely on proxies that may not fully represent market risk, leading to potential misestimation of risk-return relationships.

Question 18

Explain how the inclusion of momentum as a factor enhances the Fama-French model.

Answer 18

Momentum captures return persistence based on past performance, complementing size and value factors by addressing a behavioral aspect of asset returns not explained by the original 3-factor model.

Question 19

Assess the challenges in estimating beta using historical data.

Answer 19

Estimating beta with historical data faces issues like time-varying beta, limited sample periods, and noise from idiosyncratic returns, which can distort systematic risk measurement.

Question 20

Justify the use of multifactor models over single-factor models in modern finance.

Answer 20

Multifactor models better capture the complexities of asset returns by incorporating multiple systematic risks, such as size, value, momentum, and liquidity, offering improved accuracy over single-factor models like CAPM.

Question 21

Why is beta central to CAPM’s theoretical framework?

Answer 21

Beta quantifies systematic risk, the only type of risk rewarded in CAPM, distinguishing it from idiosyncratic risk, which diversification eliminates.

Question 22

How does the security market line (SML) illustrate CAPM theory?

Answer 22

The SML shows the linear relationship between beta and expected return, reflecting the risk-return tradeoff as theorized by CAPM.

Question 23

What role does the risk-free rate play in CAPM?

Answer 23

The risk-free rate anchors the expected return, representing the return on an asset with zero systematic risk.

Question 24

Why are size and value factors included in the Fama-French model?

Answer 24

They address anomalies like the small-cap effect and value premium, which CAPM cannot explain, reflecting additional dimensions of systematic risk.

Question 25

How does the Fama-MacBeth regression test CAPM assumptions?

Answer 25

It evaluates whether the risk premium is consistent with CAPM predictions by analyzing cross-sectional and temporal relationships between beta and returns.

Question 26

What is the theoretical basis for including a liquidity factor in asset pricing?

Answer 26

Liquidity impacts transaction costs and market efficiency, creating a systematic risk dimension that affects expected returns.

Question 27

How does Roll’s critique challenge the theoretical validity of CAPM tests?

Answer 27

Roll argues that CAPM’s assumptions hinge on an unobservable true market portfolio, undermining the empirical tests’ conclusions if proxies deviate from the theoretical portfolio.

Question 28

Why does the Fama-French model assume a linear relationship between factors and returns?

Answer 28

It builds on CAPM’s framework, positing that returns are linearly related to systematic risks, but extends it by adding factors that capture additional dimensions of risk.

Question 29

How do momentum-based models explain asset return anomalies?

Answer 29

They theorize that behavioral biases and market inefficiencies create persistent trends, challenging efficient market assumptions and extending factor-based pricing models.

Question 30

Why are multifactor models considered more robust than single-factor models?

Answer 30

They incorporate multiple sources of systematic risk, improving explanatory power and addressing empirical anomalies that single-factor models like CAPM fail to capture.