Chapter 13 - Empirical Evidence on Security Returns

CHAPTER13:EMPIRICALEVIDENCEONSECURITYRETURNS
PROBLEMSETS
1.

Even if the single-factor CCAPM (with a consumption-tracking portfolio used as the

index) performs better than the CAPM, it is still quite possible that the consumption
portfolio does not capture the size and growth characteristics captured by the SMB (i.e.,
small minus big capitalization) and HML (i.e., high minus low book-to-market ratio)
factors of the Fama-French three-factor model. Therefore, it is expected that the FamaFrench model with consumption provides a better explanation of returns than does the
model with consumption alone.

2.

Wealth and consumption should be positively correlated and, therefore,

market volatility and consumption volatility should also be positively
correlated. Periods of high market volatility might coincide with
periods of high consumption volatility. The conventional CAPM
focuses on the covariance of security returns with returns for the
market portfolio (which in turn tracks aggregate wealth) while the
consumption-based CAPM focuses on the covariance of security
returns with returns for a portfolio that tracks consumption growth.
However, to the extent that wealth and consumption are correlated,
both versions of the CAPM might represent patterns in actual returns
reasonably well.
To see this formally, suppose that the CAPM and the consumptionbased model are approximately true. According to the conventional
CAPM, the market price of risk equals expected excess market return
divided by the variance of that excess return. According to the
consumption-beta model, the price of risk equals expected excess
market return divided by the covariance of R M with g, where g is the
rate of consumption growth. This covariance equals the correlation of
RM with g times the product of the standard deviations of the
variables. Combining the two models, the correlation between R M and
g equals the standard deviation of RM divided by the standard
deviation of g. Accordingly, if the correlation between R M and g is
relatively stable, then an increase in market volatility will be
accompanied by an increase in the volatility of consumption growth.

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Chapter 13 - Empirical Evidence on Security Returns

Note:
For the followingproblems,thefocusisontheestimationprocedure.Tokeep
theexercisefeasible,thesamplewaslimitedtoreturnsonninestocksplusamarket
indexandasecondfactoroveraperiodof12years.Thedataweregeneratedtoconform
toatwofactorCAPMsothatactualratesofreturnequalCAPMexpectationsplus
randomnoise,andthetrueinterceptoftheSCLiszeroforallstocks.Theexercisewill
provideafeelforthepitfallsofverifyingsocialsciencemodels.However,duetothe
smallsizeofthesample,resultsarenotalwaysconsistentwiththefindingsofother
studiesasreportedinthechapter.
3.

UsingtheregressionfeatureofExcelwiththedatapresentedinthetext,thefirstpass
(SCL)estimationresultsare:
Stock:
RSquare
Observations
Alpha
Beta
tAlpha
tBeta

A
B
C
D
0.06 0.06 0.06 0.37
12
12
12
12
9.00 0.63 0.64 5.05
0.47 0.59 0.42 1.38
0.73 0.04 0.06 0.41
0.81 0.78 0.78 2.42

E
F
0.17 0.59
12
12
0.73 4.53
0.90 1.78
0.05 0.45
1.42 3.83

G
H
0.06 0.67
12
12
5.94 2.41
0.66 1.91
0.33 0.27
0.78 4.51

4.

ThehypothesesforthesecondpassregressionfortheSMLare:
Theinterceptiszero;and,
Theslopeisequaltotheaveragereturnontheindexportfolio.

5.

Thesecondpassdatafromfirstpass(SCL)estimatesare:
Average
E
x
c
e
s
s
Beta

R
e
t
u
r
n
A
5.18
0.47
B
4.19
0.59
C
2.75
0.42
D
6.15
1.38
E
8.05
0.90
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I
0.70
12
5.92
2.08
0.64
4.81

Chapter 13 - Empirical Evidence on Security Returns

F
G
H
I
M

9.90
11.32
13.11
22.83
8.12

1.78
0.66
1.91
2.08

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Chapter 13 - Empirical Evidence on Security Returns

Thesecondpassregressionyields:
RegressionStatistics
MultipleR
0.7074
RSquare
0.5004
AdjustedRSquare 0.4291
StandardError
4.6234
Observations
9

Intercept
Slope

Coefficients

Standard
Error

tStatistic
for=0

tStatistic
for=8.12

3.92
5.21

2.54
1.97

1.54
2.65

1.48

6.

Aswesawinthechapter,theinterceptistoohigh(3.92%peryearinsteadof0)andthe
slopeistooflat(5.21%insteadofapredictedvalueequaltothesampleaveragerisk
premium:rMrf=8.12%).Theinterceptisnotsignificantlygreaterthanzero(thet
statisticislessthan2)andtheslopeisnotsignificantlydifferentfromitstheoretical
value(thetstatisticforthishypothesisis1.48).Thislackofstatisticalsignificanceis
probablyduetothesmallsizeofthesample.

7.

ArrangingthesecuritiesinthreeportfoliosbasedonbetasfromtheSCLestimates,the
firstpassinputdataare:
Year
ABC
1
15.05
2
16.76
3
19.67
4
15.83
5
47.18
6
2.26
7
18.67
8
6.35
9
7.85
10
21.41
11
2.53
12
0.30
Average
4.04
Std.Dev. 19.30

DEG
25.86
29.74
5.68
2.58
37.70
53.86
15.32
36.33
14.08
12.66
50.71
4.99
8.51
29.47

FHI
56.69
50.85
8.98
35.41
3.25
75.44
12.50
32.12
50.42
52.14
66.12
20.10
15.28
43.96

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Chapter 13 - Empirical Evidence on Security Returns

Thefirstpass(SCL)estimatesare:
ABC
0.04
12
2.58
0.18
0.42
0.62

RSquare
Observations
Alpha
Beta
tAlpha
tBeta

DEG
0.48
12
0.54
0.98
0.08
3.02

FHI
0.82
12
0.34
1.92
0.06
6.83

GroupingintoportfolioshasimprovedtheSCLestimatesasisevidentfromthehigher
RsquareforPortfolioDEGandPortfolioFHI.Thismeansthatthebeta(slope)is
measuredwithgreaterprecision,reducingtheerrorinmeasurementproblematthe
expenseofleavingfewerobservationsforthesecondpass.
Theinputsforthesecondpassregressionare:

ABC
DEH
FGI
M

Average
Excess
Return
4.04
8.51
15.28
8.12

Beta
0.18
0.98
1.92

Thesecondpassestimatesare:
Regression
Statistics
MultipleR
RSquare
AdjustedR
Square
StandardError
Observations

0.9975
0.9949
0.9899
0.5693
3

Coefficients
Intercept
Slope

2.62
6.47

Standard
Error
0.58
0.46

tStatistic
for=0
4.55
14.03

tStatistic
for=8.12
3.58

Despitethedeceaseintheinterceptandtheincreaseinslope,theinterceptisnow
significantlypositive,andtheslopeissignificantlylessthanthehypothesizedvalueby
morethanthreetimesthestandarderror.

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Chapter 13 - Empirical Evidence on Security Returns

8.

Rollscritiquesuggeststhattheproblembeginswiththemarketindex,whichisnotthe
theoreticalportfolioagainstwhichthesecondpassregressionshouldhold.Hence,even
iftherelationshipisvalidwithrespecttothetrue(unknown)index,wemaynotfindit.
Asaresult,thesecondpassrelationshipmaybemeaningless.

9.
CAPITAL MARKET LINE FROM SAMPLE DATA

25
I

CML

Average Return

20

FHI

15

H
G
10

F
Market

DEG

E
A

D
B

ABC
C
0
0

10

20

30

40

50

60

70

Standard Deviation

ExceptforStockI,whichrealizedanextremelypositivesurprise,theCMLshowsthat
theindexdominatesallothersecurities,andthethreeportfoliosdominateallindividual
stocks.Thepowerofdiversificationisevidentdespitetheverysmallsamplesize.
10.

Thefirstpass(SCL)regressionresultsaresummarizedbelow:
A
B
C
D
E
F
G
H
RSquare
0.07 0.36 0.11 0.44 0.24 0.84 0.12 0.68
Observations 12
12
12
12
12
12
12
12
Intercept
9.19 1.89 1.00 4.48 0.17 3.47 5.32 2.64
BetaM
0.47 0.58 0.41 1.39 0.89 1.79 0.65 1.91
BetaF
0.35 2.33 0.67 1.05 1.03 1.95 1.15 0.43
tIntercept
0.71 0.13 0.08 0.37 0.01 0.52 0.29 0.28
tBetaM
0.77 0.87 0.75 2.46 1.40 5.80 0.75 4.35
tBetaF
0.34 2.06 0.71 1.08 0.94 3.69 0.77 0.57

13-6

I
0.71
12
5.66
2.08
0.48
0.59
4.65
0.63

Chapter 13 - Empirical Evidence on Security Returns

11. The hypotheses for the second-pass regression for the two-factor SML
are:
Theinterceptiszero;
Themarketindexslopecoefficientequalsthemarketindexaveragereturn;and,
Thefactorslopecoefficientequalstheaveragereturnonthefactor.
(Notethatthefirsttwohypothesesarethesameasthoseforthesinglefactormodel.)
12.

Theinputsforthesecondpassregressionare:
Average
Excess
BetaM
BetaF
Return
A
5.18
0.47
0.35
B
4.19
0.58
2.33
C
2.75
0.41
0.67
D
6.15
1.39
1.05
E
8.05
0.89
1.03
F
9.90
1.79
1.95
G
11.32
0.65
1.15
H
13.11
1.91
0.43
I
22.83
2.08
0.48
M
8.12
F
0.60
Thesecondpassregressionyields:
RegressionStatistics
MultipleR
0.7234
RSquare
0.5233
AdjustedRSquare 0.3644
StandardError
4.8786
Observations
9
Coefficients
Intercept
BetaM
BetaF

3.35
5.53
0.80

Standard
Error
2.88
2.16
1.42

tStatistic
for=0
1.16
2.56
0.56

tStatistic
for=8.12
1.20

tStatistic
for=0.6

0.14

Theseresultsareslightlybetterthanthoseforthesinglefactortest;thatis,theintercept
issmallerandtheslopeonMisslightlygreater.Wecannotexpectagreatimprovement
sincethefactorweaddeddoesnotappeartocarryalargeriskpremium(averageexcess
returnislessthan1%),anditseffectonmeanreturnsisthereforesmall.Thedatadonot
rejectthesecondfactorbecausetheslopeisclosetotheaverageexcessreturnandthe
differenceislessthanonestandarderror.However,withthissamplesize,thepowerof
thistestisextremelylow.
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Chapter 13 - Empirical Evidence on Security Returns

13.

Whenweusetheactualfactor,weimplicitlyassumethatinvestorscanperfectly
replicateit,thatis,theycaninvestinaportfoliothatisperfectlycorrelatedwiththe
factor.Whenthisisnotpossible,onecannotexpecttheCAPMequation(thesecond
passregression)tohold.Investorscanuseareplicatingportfolio(aproxyforthefactor)
thatmaximizesthecorrelationwiththefactor.TheCAPMequationisthenexpectedto
holdwithrespecttotheproxyportfolio.
UsingtheborderedcovariancematrixoftheninestocksandtheExcelSolverwe
produceaproxyportfolioforfactorF,denotedPF.Topreservethescale,weinclude
constraintsthatrequirethenineweightstobeintherangeof[1,1]andthatthemean
equalthefactormeanof0.60%.Theresultantweightsfortheproxyandperiodreturns
are:
ProxyPortfolioforFactorF(PF)
Weightson
PFHolding
Universe Year
Period
Stocks
Returns
A
0.14
1
33.51
B
1.00
2
62.78
C
0.95
3
9.87
D
0.35
4
153.56
E
0.16
5
200.76
F
1.00
6
36.62
G
0.13
7
74.34
H
0.19
8
10.84
I
0.06
9
28.11
10
59.51
11
59.15
12
14.22
Average 0.60
Thisproxy(PF)hasanRsquarewiththeactualfactorof0.80.
WenextperformthefirstpassregressionsforthetwofactormodelusingPFinsteadof
P:
Rsquare
Observations
Intercept
BetaM
BetaPF
tIntercept
tBetaM
tBetaPF

A
B
C
D
E
F
0.08 0.55 0.20 0.43 0.33 0.88
12
12
12
12
12
12
9.28 2.53 1.35 4.45 0.23 3.20
0.50 0.80 0.49 1.32 1.00 1.64
0.06 0.42 0.16 0.13 0.21 0.29
0.72 0.21 0.12 0.36 0.02 0.55
0.83 1.43 0.94 2.29 1.66 6.00
0.44 3.16 1.25 0.97 1.47 4.52

G
H
0.16 0.71
12
12
4.99 2.92
0.76 1.97
0.21 0.11
0.27 0.33
0.90 4.67
1.03 1.13

I
0.72
12
5.54
2.12
0.08
0.58
4.77
0.78

NotethatthebetasoftheninestocksonMandtheproxy(PF)aredifferentfromthose
inthefirstpasswhenweusetheactualproxy.
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Chapter 13 - Empirical Evidence on Security Returns

The first-pass regression for the two-factor model with the proxy yields:

A
B
C
D
E
F
G
H
I
M
PF

Average
Excess
Return
5.18
4.19
2.75
6.15
8.05
9.90
11.32
13.11
22.83
8.12
0.6

BetaM

BetaPF

0.50
0.80
0.49
1.32
1.00
1.64
0.76
1.97
2.12

0.06
0.42
0.16
0.13
0.21
0.29
0.21
0.11
0.08

Thesecondpassregressionyields:
RegressionStatistics
MultipleR
0.71
RSquare
0.51
AdjustedRSquare
0.35
StandardError
4.95
Observations
9
Coefficients
Intercept
BetaM
BetaPF

3.50
5.39
0.26

Standard
Error
2.99
2.18
8.36

tStatistic
for=0
1.17
2.48
0.03

tStatistic
for=8.12
1.25

tStatistic
for=0.6

0.04

Wecanseethattheresultsaresimilarto,butslightlyinferiorto,thosewiththeactual
factor,sincetheinterceptislargerandtheslopecoefficientsmaller.Notealsothatwe
usehereaninsampletestratherthantestswithfuturereturns,whichismoreforgiving
thananoutofsampletest.

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Chapter 13 - Empirical Evidence on Security Returns

14.

We assume that the value of your labor is incorporated in the calculation of the rate of
return for your business. It would likely make sense to commission a valuation of your
business at least once each year. The resultant sequence of figures for percentage change
in the value of the business (including net cash withdrawals from the business in the
calculations) will allow you to derive a reasonable estimate of the correlation between the
rate of return for your business and returns for other assets. You would then search for
industries having the lowest correlations with your portfolio, and identify exchange
traded funds (ETFs) for these industries. Your asset allocation would then be comprised
of your business, a market portfolio ETF, and the low-correlation (hedge) industry ETFs.
Assess the standard deviation of such a portfolio with reasonable proportions of the
portfolio invested in the market and in the hedge industries. Now determine where you
want to be on the resultant CAL. If you wish to hold a less risky overall portfolio and to
mix it with the risk-free asset, reduce the portfolio weights for the market and for the
hedge industries in an efficient way.

CFAPROBLEMS
1.

(i)Betasareestimatedwithrespecttomarketindexesthatareproxiesforthetrue
marketportfolio,whichisinherentlyunobservable.
(ii)EmpiricaltestsoftheCAPMshowthataveragereturnsarenotrelatedtobetain
themannerpredictedbythetheory.TheempiricalSMLisflatterthanthetheoretical
one.
(iii)Multifactormodelsofsecurityreturnsshowthatbeta,whichisaonedimensional
measureofrisk,maynotcapturethetrueriskofthestockofportfolio.

2.

a.

The basic procedure in portfolio evaluation is to compare the returns on a managed

portfolio to the return expected on an unmanaged portfolio having the same risk,
using the SML. That is, expected return is calculated from:
E(rP ) = rf + P [E(rM ) rf ]
where rf is the risk-free rate, E(rM ) is the expected return for the unmanaged
portfolio (or the market portfolio), and P is the beta coefficient (or systematic
risk) of the managed portfolio. The performance benchmark then is the unmanaged
portfolio. The typical proxy for this unmanaged portfolio is an aggregate stock
market index such as the S&P 500.

b.

The benchmark error might occur when the unmanaged portfolio used in the
evaluation process is not optimized. That is, market indices, such as the S&P 500,
chosen as benchmarks are not on the managers ex ante mean/variance efficient
frontier.

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Chapter 13 - Empirical Evidence on Security Returns

3.

c.

Your graph should show an efficient frontier obtained from actual returns, and a
different one that represents (unobserved) ex-ante expectations. The CML and
SML generated from actual returns do not conform to the CAPM predictions, while
the hypothesized lines do conform to the CAPM.

d.

The answer to this question depends on ones prior beliefs. Given a consistent track
record, an agnostic observer might conclude that the data support the claim of
superiority. Other observers might start with a strong prior that, since so many
managers are attempting to beat a passive portfolio, a small number are bound to
produce seemingly convincing track records.

e.

The question is really whether the CAPM is at all testable. The problem is that even
a slight inefficiency in the benchmark portfolio may completely invalidate any test of
the expected return-beta relationship. It appears from Rolls argument that the best
guide to the question of the validity of the CAPM is the difficulty of beating a
passive strategy.

The effect of an incorrectly specified market proxy is that the beta of Blacks portfolio is
likely to be underestimated (i.e., too low) relative to the beta calculated based on the
true market portfolio. This is because the Dow Jones Industrial Average (DJIA), and
other market proxies, are likely to have less diversification and therefore a higher
variance of returns than the true market portfolio as specified by the capital asset
pricing model. Consequently, beta computed using an overstated variance will be
underestimated. This result is clear from the following formula:
Portfolio

Cov( rPortfolio , rMarket Proxy )

2Market Proxy

An incorrectly specified market proxy is likely to produce a slope for the security market
line (i.e., the market risk premium) that is underestimated relative to the true market
portfolio. This results from the fact that the true market portfolio is likely to be more
efficient (plotting on a higher return point for the same risk) than the DJIA and similarly
misspecified market proxies. Consequently, the proxy-based SML would offer less
expected return per unit of risk.

13-11