Michaelmas Term - Lecture 3 Flashcards
What did Sharpe and Cooper (1972) test and what did they find?
Share and Cooper tested annual returns and betas for portfolios. They found a strong positive relation between risk and return.
What did Black-Jensen-Scholes (1972) test? Why did they do it in the way they did? What did they find?
They tested average annual returns and betas for portfolios then estimated a cross-sectional regressions for 8 year periods.
They used portfolios because combining securities diversifies risk.
They found a strong positive relation between risk and return in the first time period, smaller in the second time period and actually negative in the third time period.
What did Fama-Macbeth (1973) test and what did they find?
They found that average returns and betas are linearly related, the expected return on a portfolio with beta = 0 is higher than 1-month t-bill returns. Therefore the risk premium is smaller than the CAPM would predict.
What do the tests of the CAPM reveal about the risk-return relation for different stocks?
High beta stocks had lower returns than the CAPM predicts and low beta stocks had higher returns than the CAPM predicts
What is the main idea of Roll’s Critique (1972)?
Roll’s Critique is that a test of the CAPM that does not use the true market portfolio is not a test of the CAPM. Regressing returns on betas gives biased coefficients. If you compute betas using any ex-post efficient portfolio you will find that average returns are a linear function of beta. All assets should be included in the portfolio and this is impossible so the CAPM cannot be tested.
What did Fama and French (1992) find?
They found that after sorting stocks by beta & size and beta & B/M ratio, returns did not necessarily increase with beta so size and B/M ratio are statistically significant
What is the relationship between book-to-market and expected return?
The higher the B/M ratio the higher the expected return
What are “value” and “growth” stocks?
Value stocks are stocks with a high B/M ration. They usually have stable cash flows and lots of tangible assets in place.
Growth stocks are stocks with a low B/M. They usually have volatile cash flows.
What are some factors that can affect the expected return that are not captured by the CAPM?
- GDP
- Interest rates
- Inflation
What is an arbitrage opportunity?
This is when an investor can make profits with zero net investment
What is the arbitrage opportunity for well-diversified portfolios with different alphas?
1) Find 2 well-diversified portfolios with different expected returns but the same betas
2) Long the portfolio with high expected return and short the other
3) Systematic risk is offset by eliminating betas
4) We are left with a zero cost, zero-variance position with profit
What macroeconomic factors can affect price changes?
1) Growth rate of industrial production
2) Change in expected inflation
3) Change in risk premium
4) Change in term structure or interest rates
What are the 3 factors of the Fama and French (1993) model?
1) Rm-Rf
2) SMB (Return on small-cap stocks minus return on high-cap stocks, small minus big)
3) HML (Return on high B/M stocks minus low B/M stocks, high minus low)
What did Fama and French (1993) find with the three-factor model?
They found that small-cap stocks were loaded positively on SMB while high B/M stocks were loaded positively on HML. They also found that the intercepts are close to zero for the smallest and largest growth firms.
How do we construct the Fama-French model?
Construction of SMB and HML: Sort all firms into two size groups (S and B) and three B/M groups (L, M and H). Form six value-weighted portfolios.
Then HML = (HS + HB)/2 - (LS + LB)/2 and SMB = (HS + MS + LS)/3 - (HB + MB +LB)/3
Size and value factors are priced. Small factors are priced. Small stocks and value stocks earn higher returns.
