Two Pillars Of Asset Pricing Flashcards
What are the two pillars of asset pricing according to Fama (2014)?
- Market Efficiency: Asset prices fully reflect all available information.
- Asset Pricing Models: Theories that explain how expected returns relate to risk.
What is the joint hypothesis problem in market efficiency tests?
The joint hypothesis problem states that when testing market efficiency, one must assume a pricing model. If a test fails, it is unclear whether the market is inefficient or the asset pricing model is incorrect.
How do anomalies challenge the Efficient Market Hypothesis (EMH)?
Anomalies such as size, value, and momentum effects suggest that asset prices do not always reflect all available information, challenging the pure form of EMH.
Why is testing the Efficient Market Hypothesis (EMH) difficult?
Testing EMH requires an assumption about expected returns. If a test rejects EMH, it could be due to market inefficiency or a bad asset pricing model (joint hypothesis problem).
What are some of the major anomalies that challenge EMH?
- Size effect - Small stocks tend to outperform large stocks.
- Value effect - High book-to-market stocks have higher returns than growth stocks.
- Momentum effect - Stocks with recent positive returns continue to outperform.
How does CAPM fail to explain the cross-section of stock returns?
CAPM only considers market beta as a risk factor but fails to explain empirical return patterns, such as the size and value effects.
How did the Fama-French Three-Factor Model improve on CAPM?
The model includes size (SMB) and value (HML) factors along with market beta, providing a better fit for observed stock returns.
What are the key limitations of the Fama-French Three-Factor Model?
The model explains size and value effects but fails to capture momentum, profitability, and investment factors.
What are the Intertemporal CAPM (ICAPM) and Consumption CAPM (CCAPM), and how do they extend traditional asset pricing models?
ICAP incorporates changing investment opportunities over time, while CCAPM links expected returns to consumption risks, but both have mixed empirical support.
Why are asset pricing models essential for market efficiency tests?
Market efficiency cannot be tested without an asset pricing model to define expected returns, making it impossible to determine whether inefficiencies exist.
How does finance compare to other economic disciplines in terms of practical application?
Finance is one of the most successful branches of economics, producing theories widely applied in portfolio management, corporate finance, and investment analysis.
What does Fama conclude about the future of asset pricing research?
Fama suggests refining asset pricing models to better capture return patterns while recognizing that no single model can fully explain market dynamics.
What role do event studies play in testing market efficiency?
Event studies examine how quickly stock prices adjust to new information. If markets are efficient, prices should incorporate new information immediately.
How does time-varying expected stock returns challenge traditional asset pricing models?
Traditional models assume constant expected returns, but empirical evidence shows expected returns vary over time due to changing risk preferences and economic conditions.
What is Fama’s critique of the term ‘bubble’ in financial markets?
Fama argues that there is no statistically reliable evidence that price declines are predictable, making the term ‘bubble’ ambiguous and unscientific.
How does behavioral finance challenge market efficiency?
Behavioral finance suggests that cognitive biases lead to systematic mispricing, challenging the rational assumptions of traditional asset pricing models.
What are the implications of the joint hypothesis problem for empirical asset pricing research?
Since efficiency and asset pricing models are inseparable, rejections of efficiency tests could indicate either market inefficiency or a flawed pricing model complicating conclusions.
