B.5 Multi-factor Models-1.pptx

B.5 Multi-factor Models-1.pptx - Outline Multifactor Models...

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Outline: Multifactor Models How well does the CAPM explain the cross- section of returns? The Fama-French three factor model and extensions Arbitrage pricing theory Venti Multi-factor models
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2 Do other factors matter? Explaining the cross-section of returns: are there “factors” other than beta that explain why some stocks have higher or lower returns? CAPM says “No” CAPM is a one factor model. In equilibrium all securities lie on SML According to the CAPM, securities off the SML are over/under-priced and should gravitate back to SML But what if some factor other than systematic risk affects r i ? Then securities off the SML may stay persistently off the SML.
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3 Do other factors matter? Example: size (small cap vs large cap) Create portfolios of stocks with same β . Divide each portfolio into small cap and large cap Graph portfolio returns after 5 years CAPM: α’s (deviations from SML) should be random But they are not Cross-section of returns can be better predicted if we also account for market cap.
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Venti Multi-factor models 4 Do other factors matter?
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Venti Multi-factor models 5 Do other factors matter? The empirical literature has identified several factors that appear to be related to average returns. The most important are: Size Effect : Small cap vs large cap (firm size). Construct variable SMB (small minus big) as r S – r B . Value Effect : high B/M vs low B/M (book to market). Construct variable HML (high minus low) as r H – r L . Other possibilities: Past stock returns (momentum/reversals), indicators of expected profitability and indicators of expected investment.
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Venti Multi-factor models 6 Fama-French three factor model r p -r f = + p [r m -r f ] + s p * SMB + h p * HML Excess Return for = portfolio abnormal market size value return premium premium premium + + + r p -r f = + p [r m -r f ] + s p * [r S -r B ] + h p * [r H -r L ]
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Venti Multi-factor models 7 Estimates for a three factor model
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Venti Multi-factor models 8 How do we interpret the size and value premiums?
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