On the power of cross-sectional and multivariate tests of the CAPM

This paper examines the power of the cross-sectional and multivariate tests of the CAPM under ideal conditions. When the CAPM is true the positively weighted market portfolio is MV-efficient and securities plot on the security market line. When the CAPM is false an alternative asset pricing model determines prices. An examination of the population intercepts, slopes and R² from cross-sectional regressions of expected returns on betas indicates that all three are unreliable indicators of whether the CAPM holds. Simulation analysis of the power of the cross-sectional tests expands on and reinforces the analysis based on the population values. The Gibbons et al. (1989) multivariate test fares much better.     

Idiosyncratic risk and the cross-section of stock returns: Merton (1987) meets Miller (1977)

Merton [1987. A simple model of capital market equilibrium with incomplete information. Journal of Finance 42, 483–510] predicts that idiosyncratic risk should be priced when investors hold sub-optimally diversified portfolios, and cross-sectional stock returns should be positively related to their idiosyncratic risk. However, the literature generally finds a negative relationship between returns and idiosyncratic risk, which is more consistent with Miller's [1977. Risk, uncertainty, and divergence of opinion. Journal of Finance 32, 1151–1168] analysis of asset pricing under short-sale constraints. We examine the cross-sectional effects of idiosyncratic risk while explicitly recognizing the confounding effects that dispersion of beliefs and short-sale constraints produce in the Merton framework. We find strong support for Merton's [1987. A simple model of capital market equilibrium with incomplete information. Journal of Finance 42, 483–510] model among stocks that have low levels of investor recognition and for which short selling is limited. For these stocks, the relation between idiosyncratic risk and expected returns is positive, as predicted by Merton [1987. A simple model of capital market equilibrium with incomplete information. Journal of Finance 42, 483–510].     

A reply to Mayers and Rice (1979)

Mayers and Rice do not resolve the basic problem in portfolio performance evaluation with the securities market line, the ambiguity introduced by being obliged to choose a market index. Other performance evaluation techniques exist and possess some superior qualities. The Mayers-Rice discussion of my critique of the capital asset pricing model (CAPM) fails to recognize the CAPM's unusual testing implications and ignores the existence of alternative asset pricing theories. Residual analysis should give approximately correct estimates of the abnormal returns caused by specific events if it is conducted with the market model.     

Estimating the cost of capital with basis assets

Instead of using industry groups or asset pricing models to estimate the cost of capital we propose using risk equivalent classes known as basis assets. A basis asset is constructed by grouping firms together whose returns indicate they share a common risk exposure, which in theory permits a precise and accurate expected return estimate. Thus, knowing to which basis asset a firm belongs, the firm’s cost of capital can be obtained. Empirically, we show that basis assets lead to superior cost of capital estimates when compared with widely used industry groupings. This means we are no longer reliant on asset pricing models or industry groups to estimate the cost of capital of a firm.     

On the Cross-Sectional Relation between Expected Returns, Betas, and Size

In this paper, I set up scenarios where the mean-variance capital asset pricing model is true and where it is false. Then I investigate whether the coefficients from regressions of population expected excess returns on population betas, and expected excess returns on betas and size, allow us to distinguish between the scenarios. I show that the coefficients from either ordinary least squares or generalized least squares regressions do not allow us to tell whether the model is true or false.     

Combining fair pricing and capital requirements for non-life insurance companies

The aim of this article is to identify fair equity-premium combinations for non-life insurers that satisfy solvency capital requirements imposed by regulatory authorities. In particular, we compare target capital derived using the value at risk concept as planned for Solvency II in the European Union with the tail value at risk concept as required by the Swiss Solvency Test. The model framework uses Merton’s jump-diffusion process for the market value of liabilities and a geometric Brownian motion for the asset process; fair valuation is conducted using option pricing theory. We show that even if regulatory requirements are satisfied under different risk measures and parameterizations, the associated costs of insolvency – measured with the insurer’s default put option value – can differ substantially.     

Do relative leverage and relative distress really explain size and book-to-market anomalies?

In a capital asset pricing model (CAPM) framework, Ferguson and Shockley [2003. Equilibrium “anomalies”. Journal of Finance 58, 2549–2580] propose two factors constructed on relative leverage and relative distress, and show that the two factors subsume Fama and French's [1993. Common risk factors in the returns on stocks and bonds. Journal of Financial Economics 33, 3–56] factors constructed on size and book-to-market (BM) in explaining the cross-sectional average returns of the 25 size-BM portfolios. Based on tests on individual securities, we find that all factors fail to fully explain the common asset-pricing anomalies. In the spirit of Merton's [1973. An intertemporal capital asset pricing model. Econometrica 41, 867–887] intertemporal CAPM, we propose an augmented five-factor model, which incorporates Ferguson and Shockley's [2003. Equilibrium “anomalies”. Journal of Finance 58, 2549–2580] factors into the Fama–French three-factor model. The empirical results show that a simple conditional version of the augmented model is able to explain most well-known asset-pricing anomalies.     

ACCOUNTING DETERMINED AND MARKET DETERMNED RISK MEASURES: SOME TESTS OF ASSOCIATION AND PREDICTIVE ABILITY

This paper examines the degree of association between certain measures of risk that commonly feature in the accounting literature, and the β coefficient, the risk measure given by the capital asset pricing model. Tests were applied to a subset of New Zealand listed public company securities. A weak association was found. Tests of the predictive ability of an accounting based regression model showed that its performance was inferior to other commonly assumed predictive models.     

Alternate approach to unify CAPM and APT

We utilize the joint elliptical distribution to model a multi-factor return generating process and derive an equilibrium multi-beta capital asset pricing model (CAPM) in which the market portfolio and a set of nonelliptical factors are sufficient to price all financial assets. Most important, it is shown that the market portfolio, while generally nonelliptical, can proxy all elliptical factors and hence: including elliptical factors in addition to the market portfolio in the pricing equation contribute nothing to asset pricing. While the representative investor prices the exposure of aggregate wealth to various nonelliptical systematic risk factors, individual securities are priced in accordance to their contributions to different aspects of the risk of aggregate wealth. The present model collapses to the Sharpe-Lintner CAPM when either the market investor is neutral to nonelliptical risk factors or when all risk factors follow a joint spherical distribution. When residuals cancel out of the market portfolio, the present model collapses to Conner (1984) pricing model.     

The impact of exchange rates on stock market returns: new evidence from seven free-floating currencies

This paper provides evidence of a significant exchange rate effect on stock index returns using data from seven selected countries practicing free-floating exchange rate regimes. This research uses parity and asset pricing theories, thus placing it within the monetary-cum-economics framework for international asset pricing. In this study, we apply a system of seemingly unrelated regression to control for unobserved heterogeneity and cross-sectional dependence. The findings constitute evidence of a statistically significant exchange rate impact on stock index returns across selected countries. These findings can be considered as falling under the arbitrage pricing approach of the international capital asset pricing model of Solnik who also used the parity-theoretical framework on exchange rate determination.     

The capital gain lock-in effect with short sales constraints

This paper develops a post-tax asset pricing model under the assumption that investors cannot defer the taxation of capital gains by costlessly short selling tax exempt perfect substitute securities. Contrary to existing literature, it is demonstrated that trading rules of immediate realization of losses and voluntary deferral of gains may not be optimal. Further, equilibrium prices are shown to be higher for stocks held by investors with large accrued capital gains and lower for stocks held by investors with small accrued capital gains or losses.     

The behavior of equity securities on the German Stock Exchange

This is the first major empirical study of the German Stock Exchange and involves the analysis of monthly data for ninety German companies from 1960 to 1970. Whereas previous studies had suggested that German securities were peculiar, this analysis showed that, except for the high positive serial correlation of returns for the larger companies, German securities had very similar properties to securities elsewhere. Betas for German companies were fairly stationary over time, with the interperiod correlation for company betas ranging from 0.2 to 0.4. When the effect of measurement error was reduced, the perceived stationarity increased and a significant regression tendency towards the mean was observed. Further, it was found that the behaviour of German securities did not conflict with the domestic capital asset pricing model and indeed supported it during the bull market of the early 1960s.     

THE NEGLECTED AND SMALL FIRM EFFECTS

This paper addresses the empirical question of whether the differential attention which companies receive affects the capital asset pricing process. The degree of attention was measured by research concentration rankings based on the number of analysts regularly following the firm's securities. The results suggest: (i) that there is a “neglected firm effect” in terms of superior performance for less researched companies and (ii) that the neglected firm effect persists over and above the small firm effect; namely, the excess returns are not fully attributable to size. The ex-post capital asset pricing model is unable to account for the differences in return across security research ranking. Several possible explanations for the results are considered but not tested.     

Pricing of liquidity risks: Evidence from multiple liquidity measures

We investigate the pricing implication of liquidity risks in the liquidity-adjusted capital asset pricing model of Acharya and Pedersen (2005), using multiple liquidity measures and their principal component. While we find that the empirical results are sensitive to the liquidity measure used in the test, we find strong evidence of pricing of liquidity risks when we estimate liquidity risks based on the first principal component across eight measures of liquidity, both in the cross-sectional and factor-model regressions. Our finding implies that the systematic component measured by each liquidity proxy is correlated across measures and the shocks to the systematic and common component of liquidity are an undiversifiable source of risk.     

Asset pricing and energy consumption risk

This paper proposes energy consumption in the US as a new measure for the consumption capital asset pricing model. We find that (i) industrial energy growth produces reasonable values for the relative risk aversion coefficient and the implied risk-free rate; (ii) compared to alternative consumption measures, industrial energy performs well in explaining the cross-sectional variation in stock returns with the lowest implied risk aversion and pricing errors; (iii) the industrial energy consumption risk model performs equally well as the Fama–French three-factor model in the cross-sectional asset pricing tests; and (iv) total energy consumption risk is priced in the presence of the Fama–French factor risks.     

Transaction Costs and the Pricing of Assets

The existence of transaction costs explains why investors do not fully diversify their portfolios. This paper examines the implications of such limited diversification on equilibrium asset prices in the framework of the capital asset pricing model. In the pricing equation obtained here an asset's risk premium depends on a weighted average of its covariance with the market and its own variance.     

COMMON STOCK RETURNS,EXPECTED INFLATION,AND THE RATIONAL EXPECTATIONS HYPOTHESIS

This paper provides empirical evidence that expected inflation has a cross-sectional impact on common stock returns. The study differs from others in that (a) the relation between stock returns and expected inflation is investigated in a two-factor asset pricing model, where the factors are the return on an equally weighted stock portfolio and the expected rate of inflation; (b) the estimation of the expected rate of inflation is based on the rational expectations hypothesis of Muth; and (c) a non-linear seemingly unrelated regression technique is employed to determine consistent and asymptotically efficient estimates. The joint hypothesis of the two-factor asset pricing model and rational expectations is not rejected in this study. It is found that the return on common stocks is significantly affected by expected inflation. Also stocks whose returns are positively correlated with expected inflation have lower expected returns.     

The Effect on a Firm's Financing and Investment Decisions of Differential Taxation as Barriers to International Investment

The effect of barriers to international investment (in the form of differential taxation) upon a firm's investment and financing decision is analyzed through a newly derived international capital asset pricing model. A firm using an improper project selection criterion which fails to account for the effect of barriers to international investment may reject a desirable project with high systematic risk, whereas it may incorrectly accept an undesirable project with low systematic risk. The financial risk premium under barriers is greater than that in the absence of barriers to international investment. In addition, the lower is the degree of barriers to international investment, the more domestic securities will gain, even when both countries impose a tax on investors of different nationality.     

Industry‐Specific Human Capital,Idiosyncratic Risk,and the Cross‐Section of Expected Stock Returns

Human capital is one of the largest assets in the economy and in theory may play an important role for asset pricing. Human capital is heterogeneous across investors. One source of heterogeneity is industry affiliation. I show that the cross‐section of expected stock returns is primarily affected by industry‐level rather than aggregate labor income risk. Furthermore, when human capital is excluded from the asset pricing model, the resulting idiosyncratic risk may appear to be priced. I find that the premium for idiosyncratic risk documented by several empirical studies depends on the covariance between stock and human capital returns.     

A One-Factor Conditionally Linear Commodity Pricing Model under Partial Information

A one-factor asset pricing model with an Ornstein–Uhlenbeck process as its state variable is studied under partial information: the mean-reverting level and the mean-reverting speed parameters are modeled as hidden/unobservable stochastic variables. No-arbitrage pricing formulas for derivative securities written on a liquid asset and exponential utility indifference pricing formulas for derivative securities written on an illiquid asset are presented. Moreover, a conditionally linear filtering result is introduced to compute the pricing/hedging formulas and the Bayesian estimators of the hidden variables.