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Unformatted text preview: 1 CAPM, ABT, Multi Factor Models, and Market Efficiency Marriott School of Management Bus M 410 Winter 2011 Rob Schonlau Last updated Feb 21, 2011 Lecture 10 Outline l Does the CAPM describe riskreturn behavior in the real world? l What alternatives exist to the CAPM? Arbitrage Pricing Theory (ABT) Multi Factor Models l Can we predict return movements? Discussion of market efficiency. 2 Question: Does the CAPM describe realworld riskreturn behavior? Answer: Yes but poorly and not in all time periods. There are other factors known to explain returns not captured by the classical CAPM. Why doesnt the CAPM work? Choice of market portfolio? Bias in betas? Taxes, borrowing and lending rates, shorting? Multiple systematic risk components? Betas change? Risk premium changes? 3 4 Issues with the CAPM 1. The model makes unrealistic assumptions 2. The parameters of the model cannot be estimated precisely Definition of the actual vs theoretical market portfolio (index model) Firms can change during the 'estimation period The model deals with expected returns but in practice we use realized returns. 3. The model does not work well If the model is right, there should be a linear relationship between returns and betas the only variable that should explain returns is betas The reality is that the relationship between betas and returns is weak other variables (size, price/book value) seem to explain differences in returns better (see research by Banz, Fama and French etc.). How do you test if the CAPM holds? CAPM related tests: According to the CAPM on average we would expect returns on individual assets and portfolios of assets to have a linear relation to betas . Do they? If we created portfolios of assets based on nonbeta characteristics (e.g., size, M/B, P/E ratios, past success etc.) we would not expect our sorting to have predictive power for returns after controlling for beta; CAPM suggests that it is only beta that should explain returns. 5 CAPM on FamaFrench sizebased portfolios and 10 and 30 year government bonds. (19261979) Does variation in betas explain the average returns on portfolios formed by size? This figure came from John Cochranes website. He has similar figures in his textbook Asset Pricing. 6 Empirical observation: smallfirm effect l Small firms have higher returns over time than you would expect compared to larger firms (Banz 1981). Especially in January. l Does firm size (using market weights) explain market returns over time? 7 CAPM on FamaFrench sizebased portfolios and 10 and 30 year government bonds. (19802010) Each portfolio represents a different size group of firm....
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This note was uploaded on 11/22/2011 for the course FINANCE BUS M 410 taught by Professor Robertschonlau during the Winter '11 term at BYU.
 Winter '11
 RobertSchonlau

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