This chapter discusses empirical tests of equilibrium models like the Capital Asset Pricing Model (CAPM) and the multifactor model. It summarizes studies that test the single-factor CAPM and find it does not fully validate the expected return-beta relationship. Multifactor models that include factors like industrial production and bond risk premiums explain returns better. However, later studies by Fama-French found firm size and book-to-market ratios better explain returns than beta. Subsequent research further examined these issues and the time-varying nature of volatility.

1. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Chapter 10
Empirical Evidence
on Security Returns

2. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Chapter Summary
 Objective: To discuss the empirical
evidence in support of equilibrium
models.
 Tests of the Single Factor Model
 Tests of the Multifactor Model
 Other Studies

3. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Overview of
Investigation
 Tests of the single factor CAPM or APT
Model
 Tests of the Multifactor APT Model
 Results are difficult to interpret
 Studies on volatility of returns over time

4. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Tests of the Single
Factor Model
Tests of the expected return beta
relationship
 First Pass Regression
 Estimate beta, average risk premiums and
unsystematic risk
 Second Pass: Using estimates from the
first pass to determine if model is
supported by the data
 Most tests do not generally support the
single factor model

5. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Thin Trading
 Many Canadian securities do not trade
very frequently
 This may cause biases in the statistical
estimates
 Several techniques exist to correct these
biases

6. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Single Factor Test
Results
Return %
Beta
Predicted
Actual

7. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Roll’s Criticism on the
Tests
 The only testable hypothesis: the mean-
variance efficiency of the market
portfolio
 All other implications are not
independently testable
 CAPM is not testable unless we use the
true market portfolio
 The benchmark error

8. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Measurement Error in
Beta
Statistical property:
 If beta is measured with error in the first
stage,
 Second stage results will be biased in the
direction the tests have supported
 Test results could result from
measurement error

9. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Conclusions on the Tests’
Results
 Tests proved that CAPM seems
qualitatively correct
 Rates of return are linear and increase with
beta
 Returns are not affected by nonsystematic risk
 But they do not entirely validate its
quantitative predictions
 The expected return-beta relationship is not
fully consistent with empirical observation.

10. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Summary Reminder
 Objective: To discuss the empirical
evidence in support of equilibrium
models.
 Tests of the Single Factor Model
 Tests of the Multifactor Model
 Other Studies

11. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Tests of the Multifactor
Model
Factors identified by Chen, Roll and Ross
in their 1986 study:
 Growth rate in industrial production
 Changes in expected inflation
 Unexpected inflation
 Changes in risk premiums on bonds
 Unexpected changes in term premium
on bonds

12. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Study Structure &
Results
 Method: Two-stage regression with
portfolios constructed by size based on
market value of equity
Findings
 Significant factors: industrial production,
risk premium on bonds and unanticipated
inflation
 Market index returns were not statistically
significant in the multifactor model

13. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Anomalies Literature
Is the CAPM or APT Model Valid?
 Numerous studies show the approach is
not valid
 Why do the studies show this result
 Other factors influence returns on securities
 Statistical problems prohibit a good test of
the model

14. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Summary Reminder
 Objective: To discuss the empirical
evidence in support of equilibrium
models.
 Tests of the Single Factor Model
 Tests of the Multifactor Model
 Other Studies

15. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Fama and French Study
(1992)
 Size and book-to-market ratios explain
returns on securities
 Beta is not a significant variable when
other variables are included
 Study results show no support for the
CAPM or APT

16. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Researchers’ Responses
to Fama and French
 Utilize better econometric techniques
 Improve estimates of beta
 Reconsider the theoretical sources and
implications of the Fama and French-
type results
 Return to the single-index model,
accounting for non-traded assets and
cyclical behavior of betas

17. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Jaganathan and Wang
Study (1996)
 Included factors for cyclical behavior of
betas and human capital
 When these factors were included the
results showed returns were a function
of beta
 Size is not an important factor when
cyclical behavior and human capital are
included

18. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Stochastic Volatility
 Stock prices change primarily in reaction
to information
 New information arrival is time varying
 Volatility is therefore not constant
through time

19. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Stock Volatility Studies
and Techniques
 Pagan and Schwert Study
 Study of 150 years of volatility on NYSE
stocks
 Volatility is not constant through time
 Improved modeling techniques should
improve results of tests of the risk-return
relationship
 GARCH Models to incorporate time varying
volatility

20. Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Equity Premium Puzzle
 Rewards for bearing risk appear too
excessive
 Possible causes:
 Unanticipated capital gains
 Survivorship bias
 Survivorship bias also creates the
appearance of abnormal returns in
market efficiency studies