Lecture_07_08

Lecture_07_08 - TestingCAPM Professor Ruslan Goyenko...

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Testing CAPM Professor Ruslan Goyenko Fall 2010 Investment 
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Investors who have mean-variance preferences, and can trade the risk  free asset, will select a portfolio on the steepest  Capital Allocation Line  (CAL), by combining the risk free asset with the  tangency portfolio . Investors select a specific point on the steepest CAL to maximize their  utility , which in turn depends on their  coefficient of risk aversion . If the  CAPM  holds, the tangency portfolio is the  market portfolio , and  optimal portfolios lie on the  Capital Market Line  (CML), and are  constructed by combining the risk free asset with the market portfolio. If a stock does not obey the CAPM formula (i.e., if the stock has a non- zero alpha), then   different than zero                    could be either produced by  a mis-specified CAPM or an inefficient market (this is the so-called  joint  hypothesis problem . In the case of inefficient market investors would then choose a point on  the new CAL that has a steeper slope than the CML. Portfolio choice: summary ( 29 0 0 < i α Fall 2010 Investment 
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Stock Anomalies: Small Firm Effect Small market capitalization firms have produced  higher average returns than was predicted by the  CAPM.   Banz (1981) and Reinganum (1981) use monthly  data and daily data respectively and find this  result.  The effect is strongest for the month of  January.  What could explain this? Liquidity?   Small firms are less liquid (the ability to buy or  sell at reasonable prices and time) than large firms  Fall 2010 Investment 
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Stock Anomalies: January Effect January has historically  produced higher returns than  other months during the year.  The effect is particularly strong  for small firms.   Tax-loss selling could be one  possible explanation. But the  effect persists in international  markets where capital gains tax  Fall 2010 Investment 
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Price/Earnings Ratio Evidence that securities with low Price/Earnings  (P/E) ratio have higher average returns. Basu (1977) explained violations from the CAPM by  using P/E ratios…for a sample of NYSE securities  there was a clear negative relationship between P/E  ratios and the average returns in excess of those  predicted by the CAPM.  Following a very simple strategy of buying the quintile of  smallest P/E securities and selling short the top quintile,  would have produced an average abnormal return of 6.75%  (annual, from 1957 to 1971).
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This note was uploaded on 02/28/2012 for the course FINE 441 taught by Professor Ruslangoyenko during the Spring '08 term at McGill.

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Lecture_07_08 - TestingCAPM Professor Ruslan Goyenko...

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