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Pricing
Doron Avramov
Professor of Finance
Winter 2015
Hebrew University of Jerusalem
Course Materials
• The Econometrics of Financial Markets, by John Y.
Campbell, Andrew W. Lo, and A. Craig MacKinlay,
Princeton University Press, 1997
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.1 Overview
Expected Return
• Statistically, an expected asset return (in excess of the
risk free rate) can be formulated as
𝔼 ri,t = αi +βi ′ 𝔼(ft ) (1.1/1)
where f denotes a set of K factor mimicking portfolios,
𝛽𝑖 is a 𝐾 vector of factor loadings, and 𝛼𝑖 reflects the
expected return component unexplained by factors, or
model mispricing.
If factors are not return spreads (e.g., consumption
growth) then the intercept does no longer represent
asset mispricing.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.1 Overview
CAPM
• The CAPM of Sharpe (1964), Lintner (1965), and Mossin (1996)
has originated the literature on asset pricing models.
• The CAPM is a general equilibrium model in a single-period
economy.
• The model imposes an economic restriction on the statistical
structure in (1.1/1).
• The unconditional version of the CAPM says that
𝔼(𝑟𝑚,𝑡 )
𝔼(𝑟𝑖,𝑡 ) = cov(𝑟𝑖,𝑡 , 𝑟𝑚,𝑡 ) , (1.2/1)
𝑣𝑎𝑟(𝑟𝑚,𝑡 )
• The higher the covariance the less desirable the asset is; thus the
asset price is lower which amounts to higher expected return.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM
Market Anomalies
• The CAPM is at odds with anomalous patterns in the cross section of stock
returns – market anomalies.
• Market anomalies include the size, book-to-market, past return (short term
reversals and intermediate term momentum), earnings momentum,
dispersion, net equity issuance, accruals, credit risk (level and changes),
asset growth, capital investment, profitability, and idiosyncratic volatility.
• There are many other cross sectional effects. A good list is in Harvey, Liu,
and Zhu (2013). “… and the Cross-Section of Expected Returns”. They
document 316 factors discovered by academia. Some of those factors are
highly correlated – hence, the ultimate number of cross sectional effects is
lower than 316 – but it is still large enough.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
• Scholars like Shiller would claim that asset prices are subject to
behavioral biases. Markets are inefficient. Higher risk need not imply
higher return.
• Both Fama and Shiller won the Nobel Prize in Economics in 2013.
• Basu (1977), Banz (1981), and Fama and French (FF) (1992)
suggest that the CAPM cannot explain the effect of size, the
dividend yield, the earnings yield, and the book-to-market on
average returns.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
Size Effect
Size effect: higher
average returns on
small stocks than
large stocks. Beta
cannot explain the
difference.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
Value Effect
• Value effect: higher average
returns on value stocks than
growth stocks. Beta cannot
explain the difference.
• Value firms: Firms with high
E/P, B/P, D/P, or CF/P. The
notion of value is that
physical assets can be
purchased at low prices.
• Growth firms: Firms with low
ratios. The notion is that
high price relative to
fundamentals reflects
capitalized growth
opportunities.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
• Jegadeesh and Titman (1993) and a great body of subsequent work uncover
abnormal returns to momentum-based strategies focusing on investment
horizons of 3, 6, 9, and 12 months.
• In sum, the literature has documented short term reversals, intermediate term
momentum, and long term reversals.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
• Because momentum loads negatively on the market, size, and value factors.
• As Asness, Moskowitz, and Pedersen (2013) note: Momentum (and value) are
everywhere.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
2. Momentum > 2.1 Momentum robustness
• Schwert (2003) demonstrates that the size and value effects in the cross
section of returns, as well as the ability of the aggregate dividend yield to
forecast the equity premium disappear, reverse, or attenuate following
their discovery.
• Haugen and Baker (1996), Rouwenhorst (1998), and Titman and Wei
(2010) document momentum in international markets (not in Japan).
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
2. Momentum > 2.1 Momentum robustness
• Korajczyk and Sadka (2004) find that momentum survives trading costs, whereas
Avramov, Chordia, and Goyal (2006) show that the profitability of the other past-
return anomaly, namely reversal, disappears in the presence of trading costs.
• Fama and French (2008) show that momentum is among the few robust anomalies
– it works also among large cap stocks.
• A very recent paper by Geczy and Samonov (2013) examine momentum during
the period 1801 through 1926 – probably the world’s longest back-test.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
2. Momentum > 2.1 Momentum robustness
• Rational: Berk, Green, and Naik (1999), Johnson (2002), and Avramov and
Hore (2013).
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
2. Momentum > 2.2 Momentum interactions
Momentum Interactions
Momentum interactions have been documented at the stock, industry, and aggregate
level.
• Hon, Lim, and Stein (2000) show that momentum profitability concentrates in small
stocks.
• Lee and Swaminathan (2000) show that momentum payoffs increase with trading
volume.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
2. Momentum > 2.2 Momentum interactions
Moskowitz and Grinblatt (1999) show that industry momentum subsumes stock
level momentum. That is, buy the past winning industries and sell the past
loosing industries.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
2. Momentum > 2.2 Momentum interactions
• Chordia and Shavikumar (2002) show that momentum is captured by business cycle
variables.
• Illiquidity – see my own paper on Time Series Momentum Payoffs and Illiquidity.
• Momentum also interacts with market states, market volatility, and market sentiment.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
2. Momentum > 2.2 Momentum interactions
Market States
• Cooper, Gutierrez, and Hameed (2008) show that momentum profitability heavily
depends on the state of the market.
• In particular, from 1929 to 1995, the mean monthly momentum profit following
positive market returns is 0.93%, whereas the mean profit following negative market
return is -0.37%.
• The study is based on the market performance over three years prior to the
implementation of the momentum strategy.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
2. Momentum > 2.2 Momentum interactions
Market sentiment
• Antoniou, Doukas, and Subrahmanyam (2010) and Stambaugh, Yu, and Yuan (2012)
find that the momentum effect is stronger when market sentiment is high.
• The former paper suggests that this result is consistent with the slow spread of bad
news during high-sentiment periods.
• Stambaugh, Yu, and Yuan (2013) use momentum along with ten other anomalies to
form a stock level composite overpricing measure. For instance, loser stocks are likely
to be overpriced due to impediments on short selling.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
Momentum Crush
• In 2009 momentum delivers a negative 85% payoff.
• The negative payoff is especially attributable to the short side of the trade.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
2. Momentum > 2.1 Momentum robustness
Momentum Spillover
• In particular, firms earning high (low) equity returns over the previous year
earn high (low) bond returns the following year.
• The spillover results are stronger among firms with lower-grade debt and
higher equity trading volume.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
2. Momentum > 2.1 Momentum robustness
• Bond momentum profits are significant in the second half of the sample
period, 1991 to 2008, and amount to 64 basis points per month.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
Earnings Momentum
• Ball and Brown (1968) document the post-earnings-announcement drift, also
known as earnings momentum.
• This anomaly refers to the fact that firms reporting unexpectedly high earnings
subsequently outperform firms reporting unexpectedly low earnings.
• The superior performance lasts for about nine months after the earnings
announcements.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
Earnings Momentum
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
• Accruals: Sloan (1996) shows that firms with high accruals earn abnormal
lower returns on average than firms with low accruals. Sloan suggests that
investors overestimate the persistence of the accrual component of earnings
when forming earnings expectations. Total accruals are calculated as changes
in noncash working capital minus depreciation expense scaled by average total
assets for the previous two fiscal years.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
• Campbell, Hilscher, and Szilagyi suggest that their finding is a challenge to standard models of rational
asset pricing. They use failure probability estimated by a dynamic logit model with both accounting and
equity market variables as explanatory variables. Using Ohlson (1980) O-score as the distress measure
yields similar results.
• Changes: Dichev and Piotroski (2001) and Avramov, Chordia, Jostova, and Philiphov (2009) document
abnormal stock price declines following credit rating downgrades.
• Interestingly, price response to credit rating changes is asymmetric – while stock and bond prices sharply
fall following credit rating downgrades – there is only a mild response to rating upgrades.
• Given their high risk low return profile – an essential question is who holds distressed stocks?
• Coelho, John, and Tafller (2012) argue that some retail investors hold distress stocks due to their lottery-
like characteristics – or they have high skewness.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
• Asset Growth:
– Cooper, Gulen, and Schill (2008) find companies that grow their total asset more
earn lower subsequent returns.
– Asset growth can be measured as the annual percentage change in total assets.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
• Capital Investment:
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
Novy-Marx argues that gross profits scaled by assets is the cleanest accounting
measure of true economic profitability. The farther down the income statement
one goes, the more polluted profitability measures become, and the less related
they are to true economic profitability.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
• The AHXZ proxy for IVOL is the standard deviation of residuals from time-
series regressions of excess stock returns on the Fama-French factors.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
• They show that IVOL by itself is unrelated to the cross section of average
returns.
• The AHXZ measure of IVOL is related to expected growth and thus it produces
a negative relation.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
• It should be noted that Swaminathan and Lee (2000) find that high turnover
stocks exhibit features of high growth stocks.
• Turnover can be constructed using various methods. For instance, for any
trading day within a particular month, compute the daily volume in either $ or
the number of traded stocks or the number of transactions. Then divide the
volume by the market capitalization or by the number of outstanding stocks.
Finally, use the daily average, within a trading month, of the volume/market
capitalization ratio as the monthly turnover.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
F-Score
• The F-Score is due to Piotroski (2000).
• The FSOCRE is designed to identify firms with the strongest improvement in their
overall financial conditions while meeting a minimum level of financial
performance.
• The FSCORE is computed as the sum of nine components which are either zero or
one.
• The overall FSCORE thus ranges between zero and nine, where a low (high) score
represents a firm with very few (many) good signals about its financial conditions.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
• A long short strategy that capitalizes on this effect generates abnormal return of
about 1.5% per month.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
Are anomalies pervasive? There have been lots of doubts as explained below.
• Lo and MacKinlay (1990) claim that the size effect may very well be the result of
unconscious, exhaustive search for a portfolio formation creating with the aim of
rejecting the CAPM. Today they would have probably provided the same insight about
many other documented anomalies.
• Schwert (2003) shows that anomalies (time-series and cross section) disappear or get
attenuated following their discovery. Momentum is an exception.
• Avramov, Chordia, and Goyal (2006) show that implementing short term reversal
strategies yields profits that do not survive direct transactions costs and costs related
to market impact.
• Wang and Yu (2010) find that the ROA anomaly exists primarily among firms with high
arbitrage costs and high information uncertainty, suggesting that mispricing is a culprit.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
• Avramov, Chordia, Jostova, and Philipov (2007a,b) (2013) show that the
momentum, dispersion, and credit risk effects, among others, concentrate in a
very small portion of high credit risk high illiquid stocks. Moreover, such strategies
are profitable especially due to the short side of the trades.
• Chordia, Subrahmanyam, and Tong (2014) find that several anomalies have
attenuated significantly over time, particularly in liquid NYSE/AMEX stocks, and
virtually none have significantly accentuated. One caveat: their analysis is
essentially unconditional.
• McLean and Pontiff (2014) study the post publication return predictability of 82
characteristics. They show that most anomalies are based on mispricing not risk.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
• Following Miller (1977), they claim that due to costly short selling there might be
overpriced stocks.
• Thus, anomalies are profitable during high sentiment periods and are attributable
to the short-leg of the trade.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
• Avramov, Chordia, Jostova, and Philipov (2013), Stambaugh, Yu, and Yuan (2012),
and Drechsler and Drechsler (2014) all seem to agree that anomalies represent an
un-exploitable stock overvaluation attributable to costly (even infeasible) short
selling.
• In my recent work in progress, I show that even the top decile of actively managed
mutual funds that invest in supposedly the “right” stocks – or stocks that are the
winners of those 11 anomalies considered by Stambaugh, Yu, and Yuan - cannot
beat the Fama-French momentum benchmarks.
• For instance, the Harrison and Kreps (1978) basic insight is that
when agents agree to disagree and short selling is impossible, asset
prices may exceed their fundamental value.
Corporate Anomalies
– Stock repurchase
– Spinoff
– Merger arbitrage
• In particular, future returns are typically low following IPOs (initial public
offerings), SEOs (seasoned public offerings), debt offerings, and bank borrowings.
• Conversely, future stock returns are typically high following stock repurchases.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
• Richardson and Sloan (2003) nicely summarize all external financing transactions
in one measure.
• They show that their comprehensive measure of external financing has a stronger
relation with future returns relative to measures based on individual transactions.
• The external financing measure, denoted by Δ𝑋𝐹𝐼𝑁 is the total cash received from
issuance of new debt and equity offerings minus cash used for retirement of
existing debt and equity. All components are normalized by the average value of
total assets.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
• This measure considers all sorts of equity offerings including common and
preferred stocks as well as all sorts of debt offerings including straight bonds,
convertible bonds, bank loans, notes, etc. Interest payments on debt as well as
dividend payments on preferred stocks are not considered as retiring debt or
equity. However, dividend payments on common stocks are considered as retiring
equity. In essence, dividends on common stocks are treated as stock repurchases.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
Where:
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.1 Empirical drawbacks
• Multifactor Models:
• Multifactor extensions of the CAPM, such as Chen, Roll, and Ross (1986), Fama and
French (1993), and Pastor and Stambaugh (2003), associate expected returns with
a tendency to move with multiple risk factors.
• On one hand, multifactor models dominate the explanation of the cross section
dispersion in expected returns.
• Mutual funds and hedge fund based trading strategies seem to outperform
benchmark indexes, even after controlling for market risk. However,
multifactor extensions explain most fund persistence
• Carhart (1997) studies mutual funds, while Fung and Hsieh (2001, 2004) focus
on hedge funds.
• Before we conclude this section, let me note that according to Roll (1977), the
CAPM is untestable since the market return is unobservable and it cannot be
measured accurately. Using proxy for the market factor could deliver
unreliable inference.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.2 Theoretical drawbacks
• The CAPM says that two stocks that are equally sensitive to market
movements must have the same expected return.
• But if one stock performs better in recessions it would be more desirable for
most investors who may actually lose their jobs or get lower salaries in
recessions.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.2 Theoretical drawbacks
• The investors will therefore bid up the price of that stock, thereby lowering
expected return.
• You may correctly argue that the market tends to go down in recessions.
• But recessions tend to be unusually severe or mild for a given level of market
returns.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.2 Theoretical drawbacks
• In the ICAPM setup, the demand for risky assets is attributed not only to the
mean variance component, as in the CAPM, but also to hedging against
unfavorable shifts in the investment opportunity set. The hedging demand is
something extra relative to the CAPM.
• Merton points out that asset’s risk should be measured by its covariance with
the marginal utility of investors, which need not be the same as the covariance
with the market return.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.2 Theoretical drawbacks
• Merton shows that multiple state variables that are sources of priced risk are
required to explain the cross section variation in expected returns.
• But Merton does not say which other state variables are priced - this gives
license to fish factors that work well in explaining the data but at the same
time they void any economic content.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.2 CAPM > 1.2.2 Theoretical drawbacks
• Indeed, the CCAPM is a single state variable model; real consumption growth
is the single factor. See details below.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.3 The Consumption CAPM — CCAPM
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.3 The Consumption CAPM — CCAPM
1 1−𝛾
𝑢 𝑐𝑡 = 𝑐𝑡 for 𝛾 ≠ 1, (1.3/1)
1−𝛾
• Notation:
– 𝑐𝑡 denotes consumption at time 𝑡
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.3 The Consumption CAPM — CCAPM
• The investor must decide how to allocate her wealth between consumption
and saving.
• The investor can freely buy or sell any amount of a security whose current
price is 𝑝𝑡 and next-period payoff is 𝑥𝑡+1 (𝑥𝑡+1 = 𝑝𝑡+1 + 𝑑𝑡+1 ).
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.3 The Consumption CAPM — CCAPM
𝑐𝑡 = 𝑒𝑡 − 𝑝𝑡 𝑦, (1.3/4)
where 𝜌 denotes the impatience parameter, also called the subjective discount
factor.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.3 The Consumption CAPM — CCAPM
• Substituting the constraints into the objective, and setting the derivative with
respect to y equal to zero, we obtain the first order condition for an optimal
consumption and portfolio choice,
• The left hand side in (1.3/6) reflects the loss in utility from consuming less as
the investor buys an additional unit of the asset.
• The right hand side describes the expected increase in utility obtained from
the extra payoff at 𝑡 + 1 attributed to this additional unit of the asset.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.3 The Consumption CAPM — CCAPM
𝜌𝑢′ (𝑐𝑡+1 )
where 𝜉𝑡+1 = stands for the pricing kernel, also known as the
𝑢′ (𝑐𝑡 )
marginal rate of substitution or the stochastic discount factor, and
𝑥𝑡+1
𝑅𝑡+1 = denotes the gross return on the security.
𝑝𝑡
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.3 The Consumption CAPM — CCAPM
> 1.3.1 Several Insights about the First Order Condition
Several Insights about the First Order Condition
• Observe from (1.3/7) that the gross risk-free rate, the rate known at time t,
𝑓
which is uncorrelated with the discount factor, is given by 𝑅𝑡,𝑡+1 = 1
/𝔼𝑡 (𝜉𝑡+1 ).
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.3 The Consumption CAPM — CCAPM
> 1.3.1 Several Insights about the First Order Condition
• Assuming lognormal consumption growth one can show that the continuously
compounded risk-free rate is
𝑓
𝑟𝑡,𝑡+1 = − ln( 𝜌) − ln 𝔼𝑡 exp( − 𝛾Δ ln 𝑐𝑡+1 ) ,
𝛾2 2
= − ln ( 𝜌) + 𝛾𝔼𝑡 (Δ ln 𝑐𝑡+1 ) − 𝜎 (Δ ln 𝑐𝑡+1 ). (1.3/8)
2 𝑡
𝑎2 2
𝜎 (𝑥)
𝔼(𝑒 𝑎𝑥 ) = 𝑒 𝔼(𝑎𝑥) 𝑒 2 . (1.3/9)
• We can see from (1.3/8) that the EIS (elasticity of inter-temporal substitution)
is 1/𝛾 which creates some problems, as discussed below.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.3 The Consumption CAPM — CCAPM
> 1.3.1 Several Insights about the First Order Condition
• In words, expected excess return on each security, stock, bond, or option, should
be proportional to the coefficient in the regression of that return on the discount
factor.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.3 The Consumption CAPM — CCAPM
> 1.3.1 Several Insights about the First Order Condition
• Focusing on the power utility function and using a first order Taylor series
expansion, we obtain
𝔼(𝑟𝑖,𝑡+1 ) ≈ 𝑟 𝑓 + 𝛽𝑖,Δ𝑐 𝜆Δ𝑐 , (1.3/11)
where
𝑐𝑜𝑣(𝑟𝑖,𝑡+1 ,𝛥𝑐)
𝛽𝑖,Δ𝑐 = , (1.3/12)
𝑣𝑎𝑟(𝛥𝑐)
𝜆Δ𝑐 = 𝛾var(Δ𝑐). (1.3/13)
• This is the discrete time version of the consumption CAPM.
• The relation is exact in continuous time.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.3 The Consumption CAPM — CCAPM
> 1.3.1 Several Insights about the First Order Condition
• The asset’s risk is defined as the covariance between the asset return and
consumption growth.
• The risk premium is obtained as the product of the investor risk aversion and
the volatility of consumption growth.
• Notice from equation (1.3/11) that the expected return on an asset is larger
the larger the covariance between the return on that asset with consumption
growth.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.3 The Consumption CAPM — CCAPM
> 1.3.1 Several Insights about the First Order Condition
The former asset will be sold for a lower price, thereby having a higher
expected return.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.3 The Consumption CAPM — CCAPM
> 1.3.2 Theoretically, the CCAPM appears preferable to the traditional CAPM
• Consumption should deliver the purest measure of good and bad times as
investors consume less when their income prospects are low or if they think
future returns will be bad.
• Empirically, however, The CCAPM has been unsuccessful even relative to the
CAPM.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.3 The Consumption CAPM — CCAPM
> 1.3.3 CCAPM: The Empirical Evidence
• They reject the model on U.S. data, finding that it cannot simultaneously
explain the time-variation of interest rates and the cross-sectional pattern of
average returns on stocks and bonds.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.3 The Consumption CAPM — CCAPM
> 1.3.3 CCAPM: The Empirical Evidence
• They regress the average returns of the 464 NYSE stocks that
were continuously traded from 1959 to 1982 on their market
betas, on consumption growth betas, and on both betas.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.3 The Consumption CAPM — CCAPM
> 1.3.3 CCAPM: The Empirical Evidence
• They find that the market betas are more strongly and robustly
associated with the cross section of average returns, and that
market beta drives out consumption beta in multiple regressions.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.3 The Consumption CAPM — CCAPM
> 1.3.3 CCAPM: The Empirical Evidence
• Recently, Amir and Bansal (2004) suggest the Long Run Risk
Model as a replacement to the CCAPM
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.3 The Consumption CAPM — CCAPM
> 1.3.3 CCAPM: The Empirical Evidence
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1. Asset pricing models > 1.4 The Consumption CAPM and the Equity Premium Puzzle
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1. Asset pricing models > 1.4 The Consumption CAPM and the Equity Premium Puzzle
1 = 𝐸(𝜉𝑅), (1.4/1)
𝐸(𝑅)−𝑅𝑓 𝜎(𝜉)
= −𝜌𝜉,𝑅 , (1.4/4)
𝜎(𝑅) 𝐸(𝜉)
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.4 The Consumption CAPM and the Equity Premium Puzzle
𝐸(𝑅)−𝑅𝑓 𝜎(𝜉)
≤ = 𝜎(𝜉)𝑅 𝑓 . (1.4/5)
𝜎(𝑅) 𝐸(𝜉)
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.4 The Consumption CAPM and the Equity Premium Puzzle
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1. Asset pricing models > 1.4 The Consumption CAPM and the Equity Premium Puzzle
• Over the past several decades in the US, real stock returns have
averaged 9% with a std. of about 20%, while the real return on T-
Bills has been about 1%.
• Thus, the historical annual market Sharpe ratio has been about
0.4.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.4 The Consumption CAPM and the Equity Premium Puzzle
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1. Asset pricing models > 1.5 The riskfree rate puzzle
𝑓 𝛾2 2
𝑟𝑡,𝑡+1 = − ln ( 𝜌) + 𝛾𝔼𝑡 (Δ ln 𝑐𝑡+1 ) − 𝜎𝑡 (Δ ln 𝑐𝑡+1 ) (1.5/1)
2
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.6 How shall we resolve the equity premium and riskfree puzzles?
– But higher risk aversion parameter implies higher risk-free rate. So higher
risk aversion reinforces the risk-free puzzle.
• Perhaps the stock returns over the last 50 years are good luck
rather than an equilibrium compensation for risk.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.6 How shall we resolve the equity premium and riskfree puzzles?
– As shown earlier, EIS and the relative risk aversion parameter are
reciprocals of each other.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.6 How shall we resolve the equity premium and riskfree puzzles?
• Epstein and Zin (1989) and Weil (1990) entertain recursive inter-temporal
utility functions that separate risk aversion from elasticity of inter-temporal
substitution, thereby separating the equity premium from the risk-free rate.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.6 How shall we resolve the equity premium and riskfree puzzles?
• Duffie and Epstein (1992) introduces the Stochastic Differential Utility which is
the continuous time version of Epstein-Zin-Weil.
• They show that under certain parameter restrictions, the risk-free rate actually
diminishes with higher risk aversion.
• Reitz (1988) comes up with an interesting idea: he brings the possibility of low
probability states of economic disaster and is able to explain the observed
equity premium.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.6 How shall we resolve the equity premium and riskfree puzzles?
• The asset pricing literature typically assumes that the growth rate is normally
distributed.
• The literature also assumes that 𝜇𝑔 and 𝜎𝑔 are known to the agents in the
economy.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.6 How shall we resolve the equity premium and riskfree puzzles?
• The student t distribution captures both the high equity premium and low
risk-free rate.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.6 How shall we resolve the equity premium and riskfree puzzles?
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1. Asset pricing models > 1.7 Long Run Risk
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1. Asset pricing models > 1.7 Long Run Risk
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1. Asset pricing models > 1.7 Long Run Risk
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1. Asset pricing models > 1.7 Long Run Risk
— In response, Zhou and Zhu (2013) propose an extra volatility factor that
helps resolve all these weaknesses.
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1. Asset pricing models > 1.8 Multifactor Models
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1. Asset pricing models > 1.8 Multifactor Models
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.8 Multifactor Models
• For instance, Roll and Ross (1980) propose factor analysis of the covariance
matrix of returns, and Connor and Korajczyk (1988) propose an asymptotic
principle components.
• Later we will study a Bayesian approach for extracting factors using a panel of
stock returns.
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1. Asset pricing models > 1.8 Multifactor Models > 1.8.1 The Fama-French Model
1. the return on the market portfolio in excess of the risk free rate of return
2. a zero net investment (spread) portfolio that is long in small firm stocks and short
in large firm stocks (SMB)
3. a zero net investment (spread) portfolio that is long in high book-to-market stocks
and short in low book-to-market stocks (HML)
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1. Asset pricing models > 1.8 Multifactor Models > 1.8.1 The Fama-French Model
• FF (1996) have shown that their model is able to explain many of the
market anomalies known back then - excluding the momentum effect.
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1. Asset pricing models > 1.8 Multifactor Models > 1.8.1 The Fama-French Model
• The six portfolios are constructed at the end of each June as the
intersections of 2 portfolios formed on market equity and 3 portfolios
formed on the ratio of book equity to market equity.
• The size breakpoint for year t is the median NYSE market equity at the
end of June of year t.
• BE/ME for June of year t is the book equity for the last fiscal year end in
t-1 divided by ME for December of t-1. The BE/ME breakpoints are the
30th and 70th NYSE percentiles.
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1. Asset pricing models > 1.8 Multifactor Models > 1.8.1 The Fama-French Model
• SMB is the average return on the three small portfolios minus the average
return on the three big portfolios.
• HML is the average return on the two value portfolios minus the average
return on the two growth portfolios.
• FF (1993) argue that their factors are state variables in an ICAPM sense.
• Liew and Vassalou (2000) make a good case for the FF assertion.
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1. Asset pricing models > 1.8 Multifactor Models > 1.8.1 The Fama-French Model
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1. Asset pricing models > 1.8 Multifactor Models > 1.8.1 The Fama-French Model
• Indeed, if you run asset pricing tests using individual stocks you
will see that the Fama-French performance is rather poor.
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1. Asset pricing models > 1.8 Multifactor Models > 1.8.2 Other Multifactor Models
2. SMB
3. HML
4. WML
5. Liquidity
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1. Asset pricing models > 1.8 Multifactor Models > 1.8.2 Other Multifactor Models
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1. Asset pricing models > 1.8 Multifactor Models > 1.8.1 The Fama-French Model
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1. Asset pricing models > 1.9 Do multifactor models really perform well?
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.9 Do multifactor models really perform well?
• Note that the risk adjusted return is obtained as the sum of intercept and
residual
∗
𝑟𝑖,𝑡 = 𝛼𝑖 + 𝜖𝑖𝑡 (1.9/2)
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.9 Do multifactor models really perform well?
• They then consider the cross section regression of risk adjusted returns on
stock level size, book to market, past return variables, and turnover.
• If indeed the pricing model does a good job in pricing individual stocks
then the slope coefficients in the cross section regressions should be
statistically indistinguishable from zero.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.9 Do multifactor models really perform well?
• That is, firm level size, book to market, past return, and turnover are still
important even when stock returns are adjusted by the SMB, HML, WML,
and liquidity factors.
• Ferson and Harvey (1999) show that alpha in multi factor models varies
with business conditions.
• Whereas the Ferson and Harvey (1999) metric is statistical, Avramov and
Chordia (2006b) demonstrate that mispricing variation with macro
variables is economically significant.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
1. Asset pricing models > 1.10 Quick summary
Quick Summary
• So the empirical evidence on model pricing abilities is disappointing
whether you take single or multi factor models whether you take
conditional or unconditional models.
• It is still nice to develop new or improve existing asset pricing theories and
test methodologies.
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1. Asset pricing models > 1.10 Quick summary
• Moreover, we will entertain some Bayesian methods that take the view
that asset pricing models, albeit non perfect, are still useful for estimating
cost of equity estimation, evaluating fund performance, and selecting
optimal portfolios.
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Estimating and Evaluating Asset
Pricing Models
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4. Estimating and Evaluating Asset Pricing Models > 4.1 Another useful cross sectional approach
• For one it avoids the data-snooping biases that are inherent in portfolio based
approaches, as noted by Lo and MacKinlay (1990).
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4. Estimating and Evaluating Asset Pricing Models > 4.1 Another useful cross sectional approach
• It is also robust to the sensitivity of asset pricing tests to the portfolio grouping
procedure.
• Avramov and Chordia (2006a) extend the BCS methodology to test pricing models with
potential time varying factor loadings.
• The first stage is a time series regression of excess returns on asset pricing factors with
time varying factor loadings.
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4. Estimating and Evaluating Asset Pricing Models > 4.1 Another useful cross sectional approach
• Under the null of exact pricing, equity characteristics should be statistically insignificant
in the cross-section.
• The practice of using risk adjusted returns, rather than gross or excess returns, is
intended to address the finite sample bias attributable to errors in estimating factor
loadings in the first-pass time series regressions.
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4. Estimating and Evaluating Asset Pricing Models > 4.1 Another useful cross sectional approach
𝐾
𝑅𝑗𝑡 = 𝐸𝑡−1 (𝑅𝑗𝑡 ) + 𝑘=1 𝛽𝑗𝑘𝑡−1 𝑓𝑘𝑡 + 𝑒𝑗𝑡 , (4.1/1)
• where 𝐸𝑡−1 is the conditional expectations operator, 𝑅𝑗𝑡 is the return on security 𝑗 at
time 𝑡, 𝑓𝑘𝑡 is the unanticipated (with respect to information available at 𝑡 − 1) time 𝑡
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4. Estimating and Evaluating Asset Pricing Models > 4.1 Another useful cross sectional approach
𝐾
𝐸𝑡−1 (𝑅𝑗𝑡 ) − 𝑅𝐹𝑡 = 𝑘=1 𝜆𝑘𝑡−1 𝛽𝑗𝑘𝑡−1 , (4.1/2)
• where 𝑅𝐹𝑡 is the risk-free rate and 𝜆𝑘𝑡 is the risk premium for factor 𝑘 at time 𝑡.
• The estimated risk-adjusted return on each security for month 𝑡 is then calculated
as:
∗ 𝐾
𝑅𝑗𝑡 ≡ 𝑅𝑗𝑡 − 𝑅𝐹𝑡 − 𝑘=1 𝛽𝑗𝑘𝑡−1 𝐹𝑘𝑡 , (4.1/3)
• where 𝐹𝑘𝑡 ≡ 𝑓𝑘𝑡 + 𝜆𝑘𝑡−1 is the sum of the factor innovation and its corresponding
risk premium and 𝛽𝑗𝑘𝑡 is the conditional beta estimated by a first-pass time-series
regression over the entire sample period as per the specification given below.
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4. Estimating and Evaluating Asset Pricing Models > 4.1 Another useful cross sectional approach
• Our risk adjustment procedure assumes that the conditional zero-beta return equals
the conditional risk-free rate, and that the factor premium is equal to the excess return
∗ 𝑀
𝑅𝑗𝑡 = 𝑐0𝑡 + 𝑚=1 𝑐𝑚𝑡 𝑍𝑚𝑗𝑡−1 + 𝑒𝑗𝑡 , (4.1/4)
• where 𝑍𝑚𝑗𝑡−1 is the value of characteristic 𝑚 for security 𝑗 at time 𝑡 − 1, and 𝑀 is the
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4. Estimating and Evaluating Asset Pricing Models > 4.1 Another useful cross sectional approach
where 𝑍𝑡−1 is a matrix including the 𝑀 firm characteristics for 𝑁𝑡 test assets
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4. Estimating and Evaluating Asset Pricing Models > 4.1 Another useful cross sectional approach
• To formalize the conditional beta framework developed here let us rewrite the
specification in (6.4/4) using the generic form
• where 𝑋𝑗𝑡−1 and 𝑍𝑗𝑡−1 are vectors of firm characteristics, 𝑧𝑡−1 denotes a
vector of macroeconomic variables, and 𝜃 represents the parameters that
capture the dependence of 𝛽 on the macroeconomic variables and the firm
characteristics.
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4. Estimating and Evaluating Asset Pricing Models > 4.1 Another useful cross sectional approach
• While we have checked the robustness of our results for the general case
where 𝑋𝑗𝑡−1 = 𝑍𝑗𝑡−1 , the paper focuses on the case where the factor loadings
depend upon firm-level size, book-to-market, and business-cycle variables.
• That is, the vector 𝑋𝑗𝑡−1 stands for size and book-to-market and the vector
𝑍𝑗𝑡−1 stands for size, book-to-market, turnover, and various lagged return
variables.
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4. Estimating and Evaluating Asset Pricing Models > 4.1 Another useful cross sectional approach
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4. Estimating and Evaluating Asset Pricing Models > 4.1 Another useful cross sectional approach
𝛽𝑗𝑡−1 = 𝛽𝑗1 + 𝛽𝑗2 𝑧𝑡−1 + 𝛽𝑗3 + 𝛽𝑗4 𝑧𝑡−1 𝑆𝑖𝑧𝑒𝑗𝑡−1 + (𝛽𝑗5 + 𝛽𝑗6 𝑧𝑡−1 )𝐵𝑀𝑗𝑡−1 , (4.1/7)
• where 𝑆𝑖𝑧𝑒𝑗𝑡−1 and 𝐵𝑀𝑗𝑡−1 are the market capitalization and the book-to-
market ratio at time 𝑡 − 1.
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4. Estimating and Evaluating Asset Pricing Models > 4.1 Another useful cross sectional approach
• The first pass time series regression for the very last specification is
𝑟𝑗𝑡 = 𝛼𝑗 + 𝛽𝑗1 𝑟𝑚𝑡 + 𝛽𝑗2 𝑧𝑡−1 𝑟𝑚𝑡 + 𝛽𝑗3 𝑆𝑖𝑧𝑒𝑗𝑡−1 𝑟𝑚𝑡
+𝛽𝑗4 𝑧𝑡−1 𝑆𝑖𝑧𝑒𝑗𝑡−1 𝑟𝑚𝑡
where 𝑟𝑗𝑡 = 𝑅𝑗𝑡 − 𝑅𝐹𝑡 and 𝑟𝑚𝑡 is excess return on the value-weighted market
index.
∗
• Then, 𝑅𝑗𝑡 in (6.4/4), the dependent variable in the cross-section regression, is
given by 𝛼𝑗 + 𝑢𝑗𝑡 .
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4. Estimating and Evaluating Asset Pricing Models > 4.1 Another useful cross sectional approach
• The time series regression (4.1/8) is run over the entire sample.
• While this entails the use of future data in calculating the factor loadings,
Fama and French (1992) indicate that this forward looking does not impact
any of the results.
• Fama and French (1992) estimate beta by assigning the firm to one of 100
size-beta sorted portfolios. Firm’s beta (proxied by the portfolio’s beta) is
allowed to evolve over time when the firm changes its portfolio classification.
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4. Estimating and Evaluating Asset Pricing Models > 4.1 Another useful cross sectional approach
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4. Estimating and Evaluating Asset Pricing Models > 4.1 Another useful cross sectional approach
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4. Estimating and Evaluating Asset Pricing Models > 4.1 Another useful cross sectional approach
• The beta pricing specification of Avramov and Chordia does not have
that unconditional multifactor interpretation since the firm-level 𝑆𝑖𝑧𝑒𝑗
and 𝐵𝑀𝑗 are asset specific – that is, they are uncommon across all test
assets.
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Stock Return Predictability
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5. Stock Return Predictability > 5.1 Predictability based on observable macro variables
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5. Stock Return Predictability > 5.1 Predictability based on observable macro variables
𝑟𝑡 = 𝑎 + 𝛽′ 𝑧𝑡−1 + 𝑢𝑡 , (5.1/1)
𝑧𝑡 = 𝑐 + 𝜌𝑧𝑡−1 + 𝑣𝑡 . (5.1/2)
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5. Stock Return Predictability > 5.2 Is the evidence on predictability robust?
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5. Stock Return Predictability > 5.2 Is the evidence on predictability robust?
> 5.2.2 Potential data mining
Potential Data Mining
• Repeated visits of the same database lead to a problem
that statisticians refer to as data mining (also model
over-fitting or data snooping).
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5. Stock Return Predictability > 5.2 Is the evidence on predictability robust?
> 5.2.2 Potential data mining
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5. Stock Return Predictability > 5.2 Is the evidence on predictability robust?
> 5.2.3 Foster, Smith & Whaley
Foster, Smith, and Whaley (1997)
• FSW adjust the test size for potential over-fitting, using
theoretical approximations as well as simulation
studies.
• They assume that
1. M potential predictors are available.
2. All possible regression combinations are tried.
3. Only 𝑚 < 𝑀 predictors with the highest 𝑅2 are reported.
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5. Stock Return Predictability > 5.2 Is the evidence on predictability robust?
> 5.2.3 Foster, Smith & Whaley
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5. Stock Return Predictability > 5.2 Is the evidence on predictability robust?
> 5.2.4 The poor out-of-sample performance of predictive regressions
• The adjustment of the test size merely help in correctly rejecting the null of no
relationship.
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5. Stock Return Predictability > 5.2 Is the evidence on predictability robust?
> 5.2.4 The poor out-of-sample performance of predictive regressions
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5. Stock Return Predictability > 5.2 Is the evidence on predictability robust?
> 5.2.4 The poor out-of-sample performance of predictive regressions
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5. Stock Return Predictability > 5.2 Is the evidence on predictability robust?
> 5.2.4 The poor out-of-sample performance of predictive regressions
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5. Stock Return Predictability > 5.2 Is the evidence on predictability robust?
>5.2.1 Finite sample bias in the slope coefficient
Finite sample bias in the slope coefficient
• Recall, we work with (assuming one predictor for
simplicity) the predictive system
𝑟𝑡 = 𝑎 + 𝛽𝑧𝑡−1 + 𝑢𝑡 , (5.2/1)
𝑧𝑡 = 𝑐 + 𝜌𝑧𝑡−1 + 𝑣𝑡 . (5.2/2)
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5. Stock Return Predictability > 5.2 Is the evidence on predictability robust?
>5.2.1 Finite sample bias in the slope coefficient
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5. Stock Return Predictability > 5.2 Is the evidence on predictability robust?
>5.2.1 Finite sample bias in the slope coefficient
Where:
𝑅 = [𝑟1 , 𝑟2 , … , 𝑟𝑇 ]′ , 𝑍 = [𝑧1 , 𝑧2 , … , 𝑧𝑇 ]′ ,
𝑈 = [𝑢1 , 𝑢2 , … , 𝑢 𝑇 ]′ , 𝑉 = [𝑣1 , 𝑣2 , … , 𝑣𝑇 ]′ ,
where 𝐸 = [𝑒1 , 𝑒2 , … , 𝑒𝑇 ]′ .
• Amihud and Hurvich (2004, 2009) advocate a nice approach to
deal with statistical inference in the presence of a small sample
bias.
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Return Distribution and Investment
Horizons
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3. Return Distribution and Investment Horizons > 3.1 Multi period Returns and Continuous Compounding
𝑟𝑡 = ln ( 1 + 𝑅𝑡 ) (3.1/1)
𝐾
𝑅(𝑡 + 1, 𝑡 + 𝐾) = 𝑘=1( 1 + 𝑅𝑡+𝑘 ), (3.1/2)
𝐾
= 𝑒𝑥𝑝 𝑘=1 𝑟𝑡+𝑘 . (3.1/3)
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3. Return Distribution and Investment Horizons > 3.1 Multi period Returns and Continuous Compounding
𝐾
𝑟𝑡+1,𝑡+𝐾 = 𝑘=1 𝑟𝑡+𝑘 (3.1/4)
• We often assume that the cc return is iid normally distributed with mean 𝜇 and
variance 𝜎 2 . Then
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3. Return Distribution and Investment Horizons > 3.1 Multi period Returns and Continuous Compounding
• Note that the lognormal distribution is not symmetric. The median of HPR is
𝐾 2
suggesting that the mean to median ratio is exp 𝜎 .
2
• This, in turn, implies that the pdf of the HPR becomes more positively skewed the
longer the investment horizon.
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3. Return Distribution and Investment Horizons > 3.2 Partitioning the return interval
• Note that
𝐻
𝑟𝑦 = ℎ=1 𝑟𝑦,ℎ . (3.2/1)
𝜇
𝐸{𝑟𝑦,ℎ } = 𝜇𝐻 = , (3.2/2)
𝐻
𝜎2
𝑣𝑎𝑟{𝑟𝑦,ℎ } = 𝜎𝐻2 = (3.2/3)
𝐻
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3. Return Distribution and Investment Horizons > 3.2 Partitioning the return interval
• Define the short-interval sample moments by 𝑟̄ and 𝑠 2 - then the estimators of 𝜇 and 𝜎
are
𝜇 = 𝐻𝑟, (3.2/4)
𝜎 2 = 𝐻𝑠 2 . (3.2/5)
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3. Return Distribution and Investment Horizons > 3.2 Partitioning the return interval
2
𝜎
= 𝐻2 𝐻 , (3.2/7)
𝑛
𝜎2
= , (3.2/8)
𝑌
• That is, partitioning the return interval does not improve the estimator of 𝜇.
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3. Return Distribution and Investment Horizons > 3.2 Partitioning the return interval
• In particular,
2
𝑣𝑎𝑟{𝐻𝑠 2 } = 𝐻2 𝑛−1 𝜎𝐻4 , (3.2/9)
2 2 𝜎4
=𝐻 , (3.2/10)
𝐻𝑌−1 𝐻 2
2𝜎 4
= . (3.2/11)
𝐻𝑌−1
• Andersen et al (2001) among many others exploit this property to estimate the realized
variance.
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3. Return Distribution and Investment Horizons > 3.3 Variance and investment horizon when
returns are predictable
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3. Return Distribution and Investment Horizons > 3.3 Variance and investment horizon when
returns are predictable
• Of course if stock returns are iid the variance growths linearly with the horizon as
noted earlier.
• However, let us assume that stock returns can be predictable by the dividend yield.
𝑟𝑡 = 𝛼 + 𝛽𝑑𝑖𝑣𝑡−1 + 𝜖𝑡 (3.3/1)
where 𝑣𝑎𝑟(𝜖𝑡 ) = 𝜎12 , 𝑣𝑎𝑟(𝜂𝑡 ) = 𝜎22 , and 𝑐𝑜𝑣(𝜖𝑡 , 𝜂𝑡 ) = 𝜎12 and the residuals
are uncorrelated in all leads and lags.
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3. Return Distribution and Investment Horizons > 3.3 Variance and investment horizon when
returns are predictable
• It follows that
• Thus, if 𝛽 2 𝜎22 + 2𝛽𝜎12 < 0 the conditional variance of two period return is less than
the twice conditional variance of one period return, which is indeed the case based on
empirical evidence.
• Then, the longer the investment horizon the less risky equities appear if one is making
investment decisions based on the current value of the dividend yield.
• Thus one would be willing to invest more in equities over longer investment horizons.
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3. Return Distribution and Investment Horizons > 3.3 Variance and investment horizon when
returns are predictable
Are Stocks Really Less Risky for the Long Run
• Pastor and Stambaugh (2012) claim that stocks are substantially more volatile over long
horizons from an investor’s perspective.
• This perspective recognizes that parameters are uncertain, even with two centuries of
data, and that observable predictors imperfectly deliver the conditional expected
return.
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Bayesian Econometrics &
Asset Pricing
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6. Bayesian econometrics and asset pricing> 6.1 Overview
Overview
• To those of you interested in Bayesian methods in economics and finance I
would highly recommend using the textbook of Zellner (1971) along with the
references below.
• It all starts with the well known Bayes Theorem that deals with conditional
probabilities
𝑃(𝐴,𝐵)
𝑃(𝐴|𝐵) = , (6.1/1)
𝑃(𝐵)
𝑃(𝐵|𝐴)𝑃(𝐴)
= (6.1/2)
𝑃(𝐵)
where 𝐴 and 𝐵 are events and 𝑃(𝐴|𝐵) is a conditional probability that event
𝐴 occurs based on the realization of event 𝐵.
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6. Bayesian econometrics and asset pricing> 6.1 Overview
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6. Bayesian econometrics and asset pricing> 6.1 Overview
• That is, given prior views about Θ as well as evidence coming up from data -
the posterior summarizes everything we know about Θ.
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6. Bayesian econometrics and asset pricing> 6.1 Overview
𝑃(𝑟|𝛩)𝑝(𝛩)
𝑃(Θ|𝑟) = (6.1/4)
𝑃(𝑟)
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6. Bayesian econometrics and asset pricing> 6.1 Overview
• Notice that 𝑃(𝑟) does not tell us anything about Θ. So we can write
𝑃(𝑟|𝛩)𝑝(𝛩)
𝑃(Θ|𝑟) = . (6.1/6)
𝛩 𝑃 (𝑟|𝛩)𝑝(𝛩)𝑑𝛩
• The posterior density could have an analytic reduced form expression if prior
beliefs are of the conjugate form or if the prior density is diffuse or improper,
as illustrated below.
• But there are many cases in which the exact form of the posterior is
unknown.
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6. Bayesian econometrics and asset pricing> 6.1 Overview
• Then we can often employ very powerful MCMC techniques to simulate the
posterior density.
• Indeed, there are many applications in finance (mostly in asset pricing but
also in corporate finance) that use MCMC methods including Gibbs Sampling,
Metropolis Hastings, and Importance Sampling.
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6. Bayesian econometrics and asset pricing> 6.1 Overview
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6. Bayesian econometrics and asset pricing > 6.2 The Case of Conjugate Priors
𝑅 = 𝑋𝐵 + 𝑈, (6.2/1)
where
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6. Bayesian econometrics and asset pricing > 6.2 The Case of Conjugate Priors
1
−2 1
𝑃(𝑏|Σ) ∝ |Σ| exp − (𝑏 − 𝑏0 )′ [Σ −1 ⊗ Ψ0 ](𝑏 − 𝑏0 ) , (6.2/3)
2
𝜈 +𝑁+1
− 0 2 1
𝑃(Σ) ∝ |Σ| exp − tr[𝑆0 Σ−1 ] , (6.2/4)
2
where
𝑏 = 𝑣𝑒𝑐(𝐵) (6.2/5)
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6. Bayesian econometrics and asset pricing > 6.2 The Case of Conjugate Priors
𝑇
−2 1
𝑃(𝑅|𝐵, Σ, 𝑋) ∝ |Σ| exp − tr (𝑅 − 𝑋𝐵)′ (𝑅 − 𝑋𝐵) Σ −1 , (6.2/6)
2
𝑇
− 1
𝑃(𝑅|𝐵, Σ, 𝑋) ∝ |Σ| 2 exp − tr 𝑆 + (𝐵 − 𝐵)′ 𝑋 ′ 𝑋(𝐵 − 𝐵) Σ −1 (6.2/7)
2
where
𝐵 = 𝑋′𝑋 −1 𝑋 ′ 𝑅. (6.2/9)
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6. Bayesian econometrics and asset pricing > 6.2 The Case of Conjugate Priors
1
× exp − tr[𝑆Σ −1 ] , (6.2/10)
2
where
𝑏 = vec(𝐵). (6.2/11)
• Combining the likelihood (8.2/10) with the prior and completing the square on
𝑏 yield
1
− 1
𝑃(𝑏|Σ, 𝑅, 𝑋) ∝ |Σ| 2 exp − (𝑏 − 𝑏)′ [Σ −1 ⊗ 𝐹](𝑏 − 𝑏) (6.2/12)
2
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6. Bayesian econometrics and asset pricing > 6.2 The Case of Conjugate Priors
𝜈+𝑁+1
− 1
𝑃(Σ|𝑅, 𝑋) ∝ |Σ| 2 exp − tr[𝑆Σ −1 ] , (6.2/13)
2
• where
𝐹 = Ψ0 + 𝑋 ′ 𝑋, (6.2/14)
𝑏 = vec(𝐵), (6.2/15)
𝐵 = 𝐹 −1 𝑋 ′ 𝑋𝐵 + 𝐹 −1 Ψ0 𝐵0 , (6.2/16)
𝑆 = 𝑆 + 𝑆0 + 𝐵′ 𝑋 ′ 𝑋𝐵 + 𝐵0 ′ Ψ0 𝐵0 − 𝐵′ 𝐹𝐵, (6.2/17)
𝜈 = 𝑇0 + 𝑇. (6.2/18)
• So the posterior for 𝐵 is normal and for Σ is inverted Wishart.
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6. Bayesian econometrics and asset pricing > 6.2 The Case of Conjugate Priors
• That is the conjugate prior idea - the prior and posterior have the same
distributions but with different parameters.
where 𝑊 = 𝐼 − 𝐹 −1 𝑋 ′ 𝑋.
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6. Bayesian econometrics and asset pricing
> 6.3 What if the posterior does not obey a reduced form expression?
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6. Bayesian econometrics and asset pricing
> 6.3 What if the posterior does not obey a reduced form expression?
• The basic APT model assumes that returns on 𝑁 risky portfolios are related to
𝐾 pervasive unknown factors.
𝑟𝑡 = 𝜇 + 𝛽𝑓𝑡 + 𝜖𝑡 , (6.3/1)
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6. Bayesian econometrics and asset pricing
> 6.3 What if the posterior does not obey a reduced form expression?
• Specifically,
𝐸 𝑓𝑡 = 0,
𝐸{𝑓𝑡 𝑓 ′ 𝑡 } = 𝐼𝐾 ,
𝐸{𝜖𝑡 |𝑓𝑡 } = 0,
𝛽 = [𝛽1 , … , 𝛽𝐾 ].
𝜇 = 𝜆0 + 𝛽1 𝜆1 + ⋯ , +𝛽𝐾 𝜆𝐾 . (6.3/2)
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6. Bayesian econometrics and asset pricing
> 6.3 What if the posterior does not obey a reduced form expression?
1 ′ ∗
𝒬2 = 𝜇 [𝐼𝑁 − 𝛽∗ (𝛽′ 𝛽∗ )−1 𝛽∗ ′ ]𝜇, (6.3/3)
𝑁
where
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6. Bayesian econometrics and asset pricing
> 6.3 What if the posterior does not obey a reduced form expression?
• However, using the Gibbs sampling technique, we can simulate the posterior
distribution of 𝑄 2 .
• Specifically, we assume that observed returns and latent factors are jointly
normally distributed.
𝑓𝑡 0 𝐼𝐾 𝛽′
∼𝑁 , . (6.3/5)
𝑟𝑡 𝜇 𝛽 𝛽𝛽′ + Σ
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6. Bayesian econometrics and asset pricing
> 6.3 What if the posterior does not obey a reduced form expression?
– Latent factors: 𝑓 = [𝑓 ′1 , … , 𝑓 ′ 𝑇 ]′
• To evaluate the pricing error we need draws from the posterior distribution
𝑃(Θ|𝑅).
• We draw from the joint posterior in a slightly different manner than that
suggested in the paper.
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6. Bayesian econometrics and asset pricing
> 6.3 What if the posterior does not obey a reduced form expression?
1
−2
𝑃0 (Θ) ∝ |Σ| = (𝜎1 … 𝜎𝑁 )−1 . (6.3/6)
𝑟 ′ 𝑡 = 𝐹𝑡 ′ 𝐵′ + 𝜖𝑡 ′ , (6.3/7)
• where
𝐹𝑡 ′ = [1, 𝑓𝑡 ′ ], (6.3/8)
𝑅 = 𝐹𝐵′ + 𝐸 (6.3/10)
• Because the likelihood function 𝑃(𝑅|Θ) (and therefore the posterior density)
cannot be expressed analytically.
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6. Bayesian econometrics and asset pricing
> 6.3 What if the posterior does not obey a reduced form expression?
𝑇
−2 1
𝑃(𝑅|Θ, 𝐹) ∝ |Σ| exp [ − tr [𝑅 − 𝐹𝐵′ ]′ [𝑅 − 𝐹𝐵′ ]Σ −1 (6.3/11)
2
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6. Bayesian econometrics and asset pricing
> 6.3 What if the posterior does not obey a reduced form expression?
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6. Bayesian econometrics and asset pricing
> 6.3 What if the posterior does not obey a reduced form expression?
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6. Bayesian econometrics and asset pricing
> 6.3 What if the posterior does not obey a reduced form expression?
• Note:
1
𝑃(𝐵|Σ, 𝐹, 𝑅) ∝ exp − tr[𝑅 − 𝐹𝐵′ ]′ [𝑅 − 𝐹𝐵′ ]Σ −1 . (6.3/19)
2
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6. Bayesian econometrics and asset pricing
> 6.3 What if the posterior does not obey a reduced form expression?
1
𝑃(𝑏|Σ, 𝐹, 𝑅) ∝ exp − [𝑏 − 𝑏]′ Σ −1 ⊗ (𝐹 ′ 𝐹) [𝑏 − 𝑏] ,
2
(6.3/20)
where
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6. Bayesian econometrics and asset pricing
> 6.3 What if the posterior does not obey a reduced form expression?
• Therefore,
• Also note:
−(𝑇+1) 𝑇𝑆𝑖2
𝑃(𝜎𝑖 |𝐵, 𝐹, 𝑅) ∝ 𝜎𝑖 exp − , (6.3/23)
2𝜎𝑖2
suggesting that:
𝑇𝑆𝑖2
∼ 𝜒 2 (𝑇). (6.3/25)
𝜎𝑖2
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6. Bayesian econometrics and asset pricing
> 6.3 What if the posterior does not obey a reduced form expression?
• Finally,
• where
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6. Bayesian econometrics and asset pricing
> 6.4 Incorporating model uncertainty - Avramov (2002) - Bayesian Model Averaging
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6. Bayesian econometrics and asset pricing
> 6.4 Incorporating model uncertainty - Avramov (2002) - Bayesian Model Averaging
• Avramov (2002) concludes that Bossaerts and Hillion fail to discover out-of-
sample predictability because they ignore model uncertainty.
• Goyal and Welch (2006) do not account for model uncertainty either.
• Indeed, in the heart of the model selection approach, one uses a specific
criterion to select a single model and then operates as if the model is correct
with a unit probability.
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6. Bayesian econometrics and asset pricing
> 6.4 Incorporating model uncertainty - Avramov (2002) - Bayesian Model Averaging
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6. Bayesian econometrics and asset pricing
> 6.4 Incorporating model uncertainty - Avramov (2002) - Bayesian Model Averaging
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6. Bayesian econometrics and asset pricing
> 6.4 Incorporating model uncertainty - Avramov (2002) - Bayesian Model Averaging
• Let us now compute the 𝑡-ratio when model uncertainty is accounted for.
2𝑀
𝛽= 𝑗=1 𝑝 ℳ𝑗 𝛽𝑗 (6.4/1)
2𝑀
𝑉𝑎𝑟(𝛽) = 𝑗=1 𝑝 (ℳ𝑗 ) 𝑉𝑎𝑟(𝛽𝑗 ) + (𝛽𝑗 − 𝛽)(𝛽𝑗 − 𝛽)′ (6.4/2)
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6. Bayesian econometrics and asset pricing
> 6.4 Incorporating model uncertainty - Avramov (2002) - Bayesian Model Averaging
• The idea here is to compute the cumulative probability for every predictor.
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6. Bayesian econometrics and asset pricing
> 6.4 Incorporating model uncertainty - Avramov (2002) - Bayesian Model Averaging
Predictive Variables
Div BM EY WML Def Tbill RET DEF TERM Jan Inf SMB HML Term
Portfolio:
0.38 0.08 0.20 0.02 0.14 0.28 0.48 0.04 0.12 0.21 0.31 0.16 0.05 0.08
SL
0 0 1 0 0 0 0 0 0 0 1 0 0 0
0.16 0.06 0.12 0.02 0.10 0.09 0.40 0.06 0.54 0.77 0.15 0.12 0.02 0.19
SM
0 0 0 0 0 0 0 0 1 1 0 0 0 0
0.07 0.05 0.06 0.03 0.06 0.04 0.49 0.03 0.35 1.00 0.06 0.08 0.02 0.22
SH
0 0 0 0 0 0 1 0 0 1 0 0 0 0
0.14 0.05 0.12 0.04 0.14 0.13 0.05 0.07 0.20 0.03 0.69 0.05 0.05 0.15
BL
0 0 0 0 0 0 0 0 0 0 1 0 0 0
0.15 0.06 0.15 0.03 0.20 0.34 0.03 0.09 0.54 0.07 0.23 0.04 0.03 0.25
BM
0 0 0 0 0 0 0 0 1 0 0 0 0 0
0.06 0.06 0.07 0.03 0.09 0.09 0.02 0.03 0.17 0.92 0.21 0.02 0.02 0.47
BH
0 0 0 0 0 0 0 0 0 1 0 0 0 1
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> 6.4 Incorporating model uncertainty - Avramov (2002) - Bayesian Model Averaging
MPE 0.0006 0.0007 0.0003 -0.0006 0.0007 -0.0002 0.0000 -0.0023 0.0001 -0.0003
t-statistic 0.4225 0.4944 0.2368 -0.3874 0.5126 -0.1551 0.0176 -1.5588 0.0365 -0.2117
Efficiency -0.0563 -0.0287 -0.2335 -0.7874 -0.4371 -0.7642 -0.7919 -0.9454 -0.8709 -0.7926
t-statistic -0.1788 -0.0863 -0.8557 -7.8065 -1.3761 -7.4691 -6.9512 -7.9715 -7.4193 -7.2763
Serial Correlation 0.0397 0.0499 0.0323 -0.0284 0.0684 -0.0043 -0.0051 0.0274 -0.0185 -0.0269
t-statistic 0.6676 0.8326 0.5494 -0.4856 1.1288 -0.0738 -0.0895 0.5024 -0.3167 -0.4659
MSE 0.2137 0.2141 0.2139 0.2333 0.2155 0.2309 0.2298 0.2319 0.2339 0.2312
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> 6.4 Incorporating model uncertainty - Avramov (2002) - Bayesian Model Averaging
MPE -0.0003 -0.0004 -0.0003 0.0005 -0.0010 0.0007 0.0012 0.0013 0.0028 0.0020
t-statistic -0.1049 -0.1659 -0.1421 0.1847 -0.3924 0.3018 0.5103 0.5099 1.1455 0.8152
Efficiency -0.2357 -0.1047 -0.4018 -0.6708 -0.4500 -0.5959 -0.5804 -0.7953 -0.7319 -0.7300
t-statistic -0.6675 -0.2572 -1.3455 -3.0407 -0.9504 -2.8158 -2.7292 -3.7994 -3.0175 -2.9242
Serial Correlation 0.0401 0.0489 0.0372 0.0036 0.0706 0.0144 0.0143 0.0417 0.0144 0.0120
t-statistic 0.6728 0.8079 0.6320 0.0655 1.1414 0.2597 0.2572 0.7386 0.2663 0.2194
MSE 0.2133 0.2133 0.2143 0.2231 0.2155 0.2197 0.2189 0.2260 0.2237 0.2239
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Rolling 0.7546 0.7577 0.7651 0.9333 0.7777 0.9041 0.8629 0.8570 0.9286 0.9347
Recursive 0.7757 0.7678 0.7930 0.8312 0.7781 0.8163 0.8233 0.8952 0.8170 0.8337
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Asset Allocation
When Returns Are IID
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The Mean Variance Framework and Estimation Risk
• Assume there are 𝑁 + 1 assets, one of which is riskless and
others are risky.
• Denote by 𝑟𝑓𝑡 and 𝑟𝑡 the rates of returns on the riskless asset and
the risky assets at time 𝑡, respectively.
• Than:
𝑅𝑡 ≡ 𝑟𝑡 − 𝑟𝑓𝑡 1𝑁 (7.1.1/1)
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• In the first step, the mean and covariance matrix of the asset
returns are estimated based on the observed data.
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1 𝑇
𝜇= 𝑡=1 𝑅𝑡 , (7.1.1/5)
𝑇
1 𝑇
𝑉= 𝑡=1( 𝑅𝑡 − 𝜇)(𝑅𝑡 − 𝜇)′ . (7.1.1/6)
𝑇
• Then, in the second step, these sample estimates are treated as if they were
the true parameters, and are simply plugged in to compute the estimated
optimal portfolio weights,
1
𝑤 ML = 𝑉 −1 𝜇. (7.1.1/7)
𝛾
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• Consequently, the utility associated with the plug-in portfolio weights can be
substantially different from 𝑈(𝑤 ∗ ).
• Intuitively, two risky assets with the same estimated expected returns of 10%
can be entirely different if the first one has an estimation error of 20%, while
the second has 1%. However, both are treated as the same in the above two-
step procedure.
• Under the normality assumption, and under the standard diffuse prior,
𝑁+1
𝑝0 (𝜇, 𝑉) ∝ |𝑉|− 2 , (7.1.1/9)
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• with
1
𝑝(𝜇 | 𝑉, 𝚽𝑇 ) ∝ |𝑉|−1/2 exp{− tr[𝑇(𝜇 − 𝜇)(𝜇 − 𝜇)′ 𝑉 −1 ]}, (7.1.1/11)
2
𝜈
−2 1
𝑃(𝑉) ∝ |𝑉| exp{− tr 𝑉 −1 (𝑇𝑉 )}, (7.1.1/12)
2
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𝑇
−2
𝜇 )′
𝑝 𝑅𝑇+1 𝚽𝑇 ∝ 𝑉 + 𝑅𝑇+1 − 𝜇 𝑅𝑇+1 − (7.1.1/13)
𝑇+1
• Winkler (1973) and Winkle and Barry (1975) are earlier examples of Bayesian
studies on predicting prices and portfolio choice.
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• Brown (1976, 1978) and Klein and Bawa (1976) lay out independently and
clearly the Bayesian predictive density approach, especially Brown (1976) who
explains thoroughly the estimation error problem and the associated Bayesian
approach.
• Later, Bawa, Brown, and Klein (1979) provide an excellent review of the early
literature.
• Under the diffuse prior, (7.1.1/9), it is known that the Bayesian optimal
portfolio weights are
1 𝑇−𝑁−2
𝑤 Bayes = 𝑉 −1 𝜇. (7.1.1/14)
𝛾 𝑇+1
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• In contrast with the classical weights 𝑤 ML , the Bayesian holds the portfolio of
proportion to 𝑉 −1 𝜇, but the proportional coefficient is
(𝑇 − 𝑁 − 2)/(𝑇 + 1) instead of 1.
• As a result, the overall position in the risky assets are generally smaller than
before.
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• Let
𝑇
𝑉 −1 = 𝑉 −1 , (7.1.1/16)
𝑇−𝑁−2
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Conjugate Prior
• The conjugate prior, which retains the same class of distributions, is a natural
and common information prior on any problem.
• This prior in our context assumes a normal prior for the mean and inverted
prior for 𝑉,
1
𝜇 | 𝑉 ∼ 𝑁(𝜇0 , 𝑉), (7.1.2/1)
𝜏
𝑉 ∼ 𝐼𝑊(𝑉0 , 𝜈0 ), (7.1.2/2)
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• where 𝜇0 is the prior mean, and 𝜏 is a prior parameter reflecting the prior
precision of 𝜇0 , and 𝜈0 is a similar parameter on 𝑉.
• Under this prior, the posterior distribution of 𝜇 and 𝑉 are of the same form as
the case for the diffuse prior, except that now the posterior mean of 𝜇 is given
by
𝜏 𝑇
𝜇= 𝜇 + 𝜇. (7.1.2/3)
𝑇+𝜏 0 𝑇+𝜏
• This says that the posterior mean is simply a weighted average of the prior and
sample.
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𝑇+1 𝑇𝜏
𝑉= 𝑉0 + 𝑇𝑉 + (𝜇0 − 𝜇 )(𝜇0 − 𝜇)′ , (7.1.2/4)
𝑇(𝜈0 +𝑁−1) 𝑇+𝜏
• Frost and Savarino (1986) provide an interesting case of the conjugate prior by
assuming the assets are with identical means, variances, and patterned co-
variances, a priori.
• This prior is related the well known 1/𝑁 rule that invests equally across 𝑁
assets.
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> 7.1.3 Hyperparameter Prior
Hyper-parameter Prior
• By introducing hyper-parameters 𝜂 and 𝜆, Jorion (1986) uses the following
prior on 𝜇,
1
𝑝0 (𝜇 | 𝜂, 𝜆) ∝ |𝑉|−1 exp{− (𝜇 − 𝜂1𝑁 )′ (𝜆𝑉)−1 (𝜇 − 𝜂1𝑁 )} (7.1.3/1)
2
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• Using diffuse priors on both 𝜂 and 𝜆, and integrating them out from a suitable
distribution, the predictive distribution of the future asset return can be
obtained as usual.
1
𝑤 PJ = (𝑉 PJ )−1 𝜇 PJ , (7.1.3/2)
𝛾
where
𝜇 PJ = (1 − 𝑣 )𝜇 + 𝑣 𝜇𝑔 1𝑁 , (7.1.3/3)
PJ 1 𝜆 1𝑁 1𝑁 ′
𝑉 = 1+ 𝑉+ , (7.1.3/4)
𝑇+𝜆 𝑇(𝑇+1+𝜆) 1𝑁 ′ 𝑉 −1 1𝑁
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𝑁+2
𝑣= , (7.1.3/5)
(𝑁+2)+𝑇(𝜇−𝜇𝑔 1𝑁 )′ 𝑉 −1 (𝜇−𝜇𝑔 1𝑁 )
𝜆 = (𝑁 + 2)/[(𝜇 − 𝜇𝑔 1𝑁 )′ 𝑉 −1 (𝜇 − 𝜇𝑔 1𝑁 )]
(7.1.3/6)
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> 7.1.4 The Black-Litterman Model
The Black-Litterman Model
The Black-Litterman (BL) Approach for Estimating Mean Returns:
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• To illustrate, you consider a K-factor model (factors are portfolio spreads) and
you run the time series regression
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𝜇𝑓1 , 𝜇𝑓2 … 𝜇𝑓𝐾 are the sample estimates of the factor mean returns.
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The BL Mean Returns
• The BL approach combines a model (CAPM) with some views, either relative
or absolute, about expected returns.
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Understanding the BL Formulation
• We need to understand the essence of the following parameters, which
characterize the mean return vector: , 𝜇 𝑒𝑞 , 𝑃, 𝜏, Ω, 𝜇𝑣
• Starting from the Σ matrix - you can choose any feasible specification either
the sample covariance matrix, or the equal correlation, or an asset pricing
based covariance.
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Constructing Equilibrium Expected Returns
• The 𝜇 𝑒𝑞 , which is the equilibrium vector of expected return, is constructed
as follows.
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𝜇𝑚 −𝑅𝑓 2
• Then, the price of risk is 𝛾 = 2 where 𝜇𝑚 and 𝜎𝑚 are the expected return
𝜎𝑚
and variance of the market portfolio.
• One could pick a range of values for 𝛾 and examine performance of each
choice.
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• Having at hand both 𝜔𝑀𝐾𝑇 and 𝛾, the equilibrium return vector is given by
𝜇 𝑒𝑞 = 𝛾Σ𝜔𝑀𝐾𝑇 (7.1.4/2)
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• To understand why, notice that if you have a utility function that generates the
tangency portfolio of the form
−1 𝜇 𝑒
𝑤𝑇𝑃 = (7.1.4/3)
𝜄′ −1 𝜇𝑒
• then using 𝜇 𝑒𝑞 as the vector of excess returns on the N assets would deliver
𝜔𝑀𝐾𝑇 as the tangency portfolio.
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What if you Directly Apply the CAPM?
• The question being – would you get the same vector of equilibrium mean
return if you directly use the CAPM?
• Yes, if…
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μ𝑒 = β𝑁×1 𝜇𝑚
𝑒
(7.1.4/4)
𝑁×1
𝑐𝑜𝑣 𝑟 𝑒 ,𝑟𝑚
𝑒 𝑐𝑜𝑣 𝑟 𝑒 , 𝑟 𝑒 ′ 𝑤𝑀𝐾𝑇 𝑤𝑀𝐾𝑇
𝛽= 2 = 2 = 2 (7.1.4/5)
𝜎𝑚 𝜎𝑚 𝜎𝑚
𝑤𝑀𝐾𝑇 𝑒
𝐶𝐴𝑃𝑀: μ𝑒 = 2 𝜇𝑚 =𝛾 𝑤𝑀𝐾𝑇 (7.1.4/6)
𝑁×1 𝜎𝑚
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𝑒 = 𝜇𝑒 ′ 𝑤
• Since 𝜇𝑚 𝑒 𝑒 ′𝑤
𝑀𝐾𝑇 and 𝑟𝑚 = 𝑟 𝑀𝐾𝑇 (7.1.4/7)
𝑒
𝜇𝑚
then 𝜇𝑒 = 2 𝑤𝑀𝐾𝑇 = 𝜇 𝑒𝑞 (7.1.4/8)
𝜎𝑚
• So indeed, if you use (i) the sample covariance matrix, rather than any other
specification, as well as (ii)
𝜇𝑚 −𝑅𝑓
𝛾= 2 (7.1.4/9)
𝜎𝑚
then the BL equilibrium expected returns and expected returns based on the
CAPM are identical.
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The P Matrix: Absolute Views
• In the BL approach the investor/econometrician forms some views about
expected returns as described below.
• P is defined as that matrix which identifies the assets involved in the views.
• The first view says that stock 3 has an expected return of 5% while the second
says that stock 5 will deliver 12%.
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• Then P is a 2 ×N matrix.
• The first row is all zero except for the fifth entry which is one.
• Likewise, the second row is all zero except for the fifth entry which is one.
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Winner, Loser, Value, and Growth Stocks:
• Winner stocks are the top 10% performers during the past six months.
• Loser stocks are the bottom 10% performers during the past six months.
• Value stocks are 10% of the stocks having the highest book-to-market ratio.
• Growth stocks are 10% of the stocks having the lowest book-to-market ratios.
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Momentum and Value Payoffs
• The momentum payoff is a return spread – return on an equal weighted
portfolio of winner stocks minus return on equal weighted portfolio of loser
stocks.
• The value payoff is also a return spread – the return differential between
equal weighted portfolios of value and growth stocks.
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• The first row gets the value 0.1 if the corresponding stock is a winner (there
are 10 winners in a universe of 100 stocks).
• It gets the value -0.1 if the corresponding stock is a loser (there are 10 losers).
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• Of course, since we have relative views here (e.g., return on winners minus
return on losers) then the sums of the first row and the sum of the second
row are both zero.
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• Rule: the sum of the row corresponding to absolute views is one, while the
sum of the row corresponding to relative views is zero.
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• Using the relative views above, the first element is the payoff to momentum
trading strategy (sample mean); the second element is the payoff to value
investing (sample mean).
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The Ω Matrix
• Ω is a K ×K covariance matrix expressing uncertainty about views.
• In the absolute views case described above Ω 1,1 denotes uncertainty about
the first view while Ω 2,2 denotes uncertainty about the second view – both
are at the discretion of the econometrician/investor.
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• Ω 2,2 denotes uncertainty about the value payoff. This is the could be the
sample variance of the value payoff.
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Deciding Upon 𝜏
• There are many debates among professionals about the right value of 𝜏.
• You can also use other values and examine how they perform in real-time
investment decisions.
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Maximizing Sharpe Ratio
• The remaining task is to run the maximization program
𝑤 ′ 𝜇𝐵𝐿
max (7.1.4/10)
𝑤 𝑤 ′ 𝛴𝑤
• such that each of the w elements is bounded below by 0 and subject to some
agreed upon upper bound, as well as the sum of the w elements is equal to
one.
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• Let us estimate the mean and covariance (V) of our N assets based on the
sample.
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• Then the vector of expected return that serves as an input for asset allocation
is given by
−1
𝜇 = Δ−1 + (𝑉𝑠𝑎𝑚𝑝𝑙𝑒 /𝑇)−1 ∙ Δ−1 𝜇𝐵𝐿 + (𝑉𝑠𝑎𝑚𝑝𝑙𝑒 /𝑇)−1 𝜇𝑠𝑎𝑚𝑝𝑙𝑒 (7.1.4/11)
• where
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𝑦𝑡 = 𝛼 + 𝐵𝑥𝑡 + 𝑢𝑡 , (7.1.5/1)
• where 𝜇𝑖 and 𝑉𝑖𝑗 (𝑖, 𝑗 = 1,2) are the corresponding partition of 𝜇 and 𝑉,
𝜇1 𝑉11 𝑉12
𝜇 = 𝜇 , 𝑉 = . (7.1.5/3)
2 𝑉21 𝑉22
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7. Bayesian Asset Allocation > 7.1 Asset allocation when returns are IID > 7.1.5 Asset Pricing Prior
• To allow for mispricing uncertainty, Pástor (2000), and Pástor and Stambaugh
(2000) specify the prior distribution of 𝛼 as a normal distribution conditional
on Σ,
1
𝛼|Σ ∼ 𝑁 0, 𝜎𝛼2 Σ , (7.1.5/4)
𝑠𝛴2
• where 𝑠Σ2 is a suitable prior estimate for the average diagonal elements of Σ.
The above alpha-Sigma link is also explored by MacKinlay and Pástor (2000) in
the classical framework.
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9. Bayesian Asset Allocation > 9.1 Asset allocation when returns are IID > 9.1.5 Asset Pricing Prior
• On the other hand, when 𝜎𝛼 = ∞, the investor believes that the pricing model
is entirely useless.
• Although the above prior is motivated from asset pricing consideration, it also
has a shrinkage interpretation.
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9. Bayesian Asset Allocation > 9.1 Asset allocation when returns are IID > 9.1.5 Asset Pricing Prior
• Where 𝜏 depends upon the sample size and the confidence of belief in the
pricing model.
• Pástor (2000) and Pástor and Stambaugh (2000) find that the asset pricing
priors make a substantial CER difference in portfolio decisions.
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7. Bayesian Asset Allocation > 7.1 Asset allocation when returns are IID > 7.1.6 Objective Prior
Objective Prior
• Previous priors are placed on 𝜇 and 𝑉, not on the solution to the problem, the
portfolio weights.
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7. Bayesian Asset Allocation > 7.1 Asset allocation when returns are IID > 7.1.6 Objective Prior
• Tu and Zhou (2009) show that the diffuse prior implies a large prior differences
in portfolios weights across assets.
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7. Bayesian Asset Allocation > 7.1 Asset allocation when returns are IID > 7.1.6 Objective Prior
• This will allow him to form a prior on the solution, from which the prior on the
parameters can be backed out.
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7. Bayesian Asset Allocation > 7.1 Asset allocation when returns are IID > 7.1.6 Objective Prior
• Because of the way such priors on the primitive parameters are motivated,
they are called objective-based priors.
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7. Bayesian Asset Allocation > 7.1 Asset allocation when returns are IID > 7.1.6 Objective Prior
• Formally, for the current portfolio choice problem, the objective-based prior
starts from a prior on 𝑤,
1
𝜇 ∼ 𝑁 𝛾𝑉𝑤0 , 𝜎𝜌2 𝑉 , (7.1.6/2)
𝑠2
Stambaugh (2002a b) have explored the role of prior information about fund
about the ability of a fund manager to pick stocks and time the market.
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7. Bayesian Asset Allocation > 7.1 Asset allocation when returns are IID
> 7.1.7 Investing in Mutual Funds
• They find that even with a high degree of skepticism about fund performance
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7. Bayesian Asset Allocation > 7.1 Asset allocation when returns are IID
> 7.1.7 Investing in Mutual Funds
• Pastor and Stambaugh recognize the possibility that the intercept in such
• In particular, consider the case wherein benchmark assets used to define fund
assets, that is, the sample alpha in the regression of non benchmark passive
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7. Bayesian Asset Allocation > 7.1 Asset allocation when returns are IID
> 7.1.7 Investing in Mutual Funds
• Thus, Pastor and Stambaugh formulate prior beliefs on both performance and
mispricing.
• Geczy, Stambaugh, and Levin (2005) apply the Pastor Stambaugh methodology
fund universe reveals the cost of imposing the socially responsible investment
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7. Bayesian Asset Allocation > 7.1 Asset allocation when returns are IID
> 7.1.7 Investing in Mutual Funds
• This SRI cost depends crucially on the investor’s views about asset pricing
models and stock-picking skill by fund managers.
• BMW and Pastor and Stambaugh assume that the prior on alpha is
independent across funds.
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7. Bayesian Asset Allocation > 7.1 Asset allocation when returns are IID
> 7.1.7 Investing in Mutual Funds
• Each fund’s alpha estimate is shrunk toward the aggregate estimate, mitigating
extreme views.
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7. Bayesian Asset Allocation > 7.2 Asset allocation with predictability
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7. Bayesian Asset Allocation > 7.3 One-period Models
One-period Models
• Consider a one-period optimizing investor who must allocate at time 𝑇
funds between the value-weighted NYSE index and one-month Treasury
bills.
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7. Bayesian Asset Allocation > 7.3 One-period Models
𝑟𝑡 = 𝑎 + 𝑏 ′ 𝑧𝑡−1 + 𝑢𝑡 , (7.3/1)
𝑧𝑡 = 𝜃 + 𝜌𝑧𝑡−1 + 𝑣𝑡 , (7.3/2)
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7. Bayesian Asset Allocation > 7.3 One-period Models
𝜎𝑢2 𝜎𝑢𝑣
Σ= . (7.3/3)
𝜎𝑣𝑢 Σ𝑣
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7. Bayesian Asset Allocation > 7.3 One-period Models
• Assuming the inverted Wishart prior distribution for Σ and multivariate normal
prior for the intercept and slope coefficients in the predictive system, the
Bayesian predictive distribution 𝑃 𝑟𝑇+1 |Φ 𝑇 obeys the Student t density.
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7. Bayesian Asset Allocation > 7.3 One-period Models
1−𝛾
(1−𝜔) 𝑒𝑥𝑝 (𝑟𝑓 )+𝜔 𝑒𝑥𝑝 (𝑟𝑓 +𝑟𝑇+1 )
𝜔∗ = arg max 𝑟𝑇+1
𝑃 𝑟𝑇+1 |Φ 𝑇 𝑑𝑟𝑇+1 (7.3/4)
𝜔 1−𝛾
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7. Bayesian Asset Allocation > 7.3 One-period Models
(𝑔) 1−𝛾
1 (1−𝜔) 𝑒𝑥𝑝 (𝑟𝑓 )+𝜔 𝑒𝑥𝑝 (𝑟𝑓 )+𝑅𝑇+1 )
𝐺
𝑔=1 (7.3/5)
𝐺 1−𝛾
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7. Bayesian Asset Allocation > 7.4 Multi-period Models
Multi-period Models
• Whereas Kandel and Stambaugh (1996) study asset
allocation in a single-period framework, Barberis (2000)
analyzes multi-period investment decisions, considering
both a buy-and-hold investor as well as an investor who
dynamically rebalances the optimal stock-bond
allocation.
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7. Bayesian Asset Allocation > 7.4 Multi-period Models
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7. Bayesian Asset Allocation > 7.4 Multi-period Models
• Avramov (2002) shows that the distribution for 𝑅𝑇+𝐾 conditional on the data
(denoted Φ 𝑇 ) and set of parameters (denoted Θ) is given by
𝑅𝑇+𝐾 |, Θ, Φ 𝑇 ∼ 𝑁 𝜆, ϒ , (7.4/1)
• where
𝜆 = 𝐾𝑎 + 𝑏 ′ (𝜌𝐾 − 𝐼𝑀 )(𝜌 − 𝐼𝑀 )−1 𝑧𝑇
+𝑏 ′ 𝜌 𝜌𝐾−1 − 𝐼𝑀 (𝜌 − 𝐼𝑀 )−1 − (𝐾 − 1)𝐼𝑀 (𝜌 − 𝐼𝑀 )−1 𝜃 (7.4/2)
𝐾 𝐾 𝐾
ϒ = 𝐾𝜎𝑢2 + 𝑘=1 𝛿 (𝑘)Σ𝑣 𝛿(𝑘)
′ + 𝑘=1 𝜎𝑢𝑣 𝛿(𝑘)′ + 𝑘=1 𝛿 (𝑘)𝜎𝑣𝑢 (7.4/3)
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7. Bayesian Asset Allocation > 7.4 Multi-period Models
• The optimal portfolio can then be found using (7.3/5) where 𝑅𝑇+𝐾 replaces
𝑅𝑇+1 and 𝐾𝑟𝑓 replaces 𝑟𝑓 .
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7. Bayesian Asset Allocation > 7.4 Multi-period Models
• Brandt, Goyal, Santa Clara, and Stroud (2005) address the challenge using a
tractable simulation based method.
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7. Bayesian Asset Allocation > 7.4 Multi-period Models
• The conditional mean and variance in an iid world increase linearly with the
investment horizon.
• Thus, there is no horizon effect when (i) returns are iid and (ii) estimation risk
is not accounted for, as indeed shown by Samuelson (1969) and Merton (1969)
in an equilibrium framework.
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7. Bayesian Asset Allocation > 7.4 Multi-period Models
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7. Bayesian Asset Allocation > 7.4 Multi-period Models
• An essential question is what are the benefits of using the Bayesian approach
in studying asset allocation with predictability?
• There are at least three important features of the Bayesian approach including
(i) the ability to account for estimation risk and model uncertainty, (ii) the
feasibility of powerful and tractable simulation methods, and (iii) the ability to
elicit economically based prior beliefs.
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7. Bayesian Asset Allocation > 7.4 Multi-period Models
• Indeed, unlike in the single period case wherein estimation risk plays virtually
no role, estimation risk does play an important role in long horizon
investments with predictability.
• Barberis shows that a long horizon investor who ignores it may over-allocate
to stocks by a sizeable amount.
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7. Bayesian Asset Allocation > 7.4 Multi-period Models
• To illustrate, even when the predictors evolve stochastically, both Kandel and
Stambaugh (1996) and Barberis (2000) assume that the initial value of the
predictive variables 𝑧0 is non-stochastic.
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7. Bayesian Asset Allocation > 7.4 Multi-period Models
• There are other several powerful numerical Bayesian algorithms such as the
Gibbs Sampler and data augmentation (see a review paper by Chib and
Greenberg (1996)) which make the Bayesian approach broadly applicable.
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7. Bayesian Asset Allocation > 7.5 Model Uncertainly and Asset Allocation
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7. Bayesian Asset Allocation > 7.5 Model Uncertainly and Asset Allocation
• For one, existing equilibrium pricing theories are not explicit about which
variables should enter the predictive regression.
• Indeed, as noted earlier, Bossaerts and Hillion (1999) confirm in-sample return
predictability, but fail to demonstrate out-of-sample predictability.
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7. Bayesian Asset Allocation > 7.5 Model Uncertainly and Asset Allocation
• For example, one may find an economic variable statistically significant based
on a particular collection of explanatory variables, but often not based on a
competing specification.
• Given that the true set of predictive variables is virtually unknown, the
Bayesian methodology of model averaging, described below, is attractive, as it
explicitly incorporates model uncertainty in asset allocation decisions.
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7. Bayesian Asset Allocation > 7.5 Model Uncertainly and Asset Allocation
2𝑀
𝑃 𝑅𝑇+𝐾 |Φ 𝑇 = 𝑗=1 𝑃 ℳ𝑗 |Φ 𝑇 Θ𝑗
𝑃 Θ𝑗 |ℳ𝑗 , Φ 𝑇 𝑃 𝑅𝑇+𝐾 |ℳ𝑗 , Θ𝑗 , Φ 𝑇 𝑑Θ𝑗 (7.5/1)
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7. Bayesian Asset Allocation > 7.5 Model Uncertainly and Asset Allocation
• Then conditional upon the model implement the two steps, noted above, of
drawing future stock returns from the model specific Bayesian predictive
distribution.
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7. Bayesian Asset Allocation > 7.6 Asset allocation when returns are IID
> 7.6.1 Stock return predictability and asset pricing models - informative priors
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7. Bayesian Asset Allocation > 7.6 Asset allocation when returns are IID
> 7.6.1 Stock return predictability and asset pricing models - informative priors
• The investor uses the sample evidence about the extent of predictability to
update various degrees of belief in a pricing model and then allocates funds
across cash and stocks.
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7. Bayesian Asset Allocation > 7.6 Asset allocation when returns are IID
> 7.6.1 Stock return predictability and asset pricing models - informative priors
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7. Bayesian Asset Allocation > 7.6 Asset allocation when returns are IID
> 7.6.1 Stock return predictability and asset pricing models - informative priors
• Now, a conditional version of an asset pricing model (with fixed beta) implies
the relation
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7. Bayesian Asset Allocation > 7.6 Asset allocation when returns are IID
> 7.6.1 Stock return predictability and asset pricing models - informative priors
rt = μ0 + μ1 zt−1 + vt , (7.6.1/6)
• In particular, note that by adding to the right hand side of (9.5.1/6) the
quantity β ft − λ0 − λ1 zt−1 , subtracting the (same) quantity βuft , and
decomposing the residual
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7. Bayesian Asset Allocation > 7.6 Asset allocation when returns are IID
> 7.6.1 Stock return predictability and asset pricing models - informative priors
μ0 = α0 + βλ0 , (7.6.1/8)
μ1 = α1 + βλ1 . (7.6.1/9)
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7. Bayesian Asset Allocation > 7.6 Asset allocation when returns are IID
> 7.6.1 Stock return predictability and asset pricing models - informative priors
μ0 = βλ0 , (7.6.1/10)
μ1 = βλ1 . (7.6.1/11)
• This means that stock returns are predictable (μ1 ≠ 0) iff factors are
predictable.
• Makes sense; after all, under pricing restrictions the systematic component of
returns on N stocks is captured by K common factors.
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7. Bayesian Asset Allocation > 7.6 Asset allocation when returns are IID
> 7.6.1 Stock return predictability and asset pricing models - informative priors
• Of course, if we relax the fixed beta assumption - time varying beta could also
be a source of predictability. More later!
• Kirby (1998) shows that returns are too predictable to be explained by asset
pricing models.
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7. Bayesian Asset Allocation > 7.6 Asset allocation when returns are IID
> 7.6.1 Stock return predictability and asset pricing models - informative priors
• Avramov and Chordia (2006b) show that strategies that invest in individual
stocks conditioning on time varying alpha perform extremely well. More later!
• What if you are a Bayesian investor who believes pricing models could be
useful albeit not perfect?
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7. Bayesian Asset Allocation > 7.6 Asset allocation when returns are IID
> 7.6.1 Stock return predictability and asset pricing models - informative priors
• Let μd and Σd (μm and Σm ) be the expected return vector and variance
covariance matrix based on the data (model).
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7. Bayesian Asset Allocation > 7.6 Asset allocation when returns are IID
> 7.6.1 Stock return predictability and asset pricing models - informative priors
• There are other quite useful shrinkage methods of Σ - see, for example,
Jagannathan and Ma (2005).
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7. Bayesian Asset Allocation > 7.6 Asset allocation when returns are IID
> 7.6.1 Stock return predictability and asset pricing models - informative priors
• In particular,
• Avramov (2004) derives asset allocation under the pricing restrictions alone,
the data alone, and pricing restrictions and data combined.
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7. Bayesian Asset Allocation > 7.6 Asset allocation when returns are IID
> 7.6.1 Stock return predictability and asset pricing models - informative priors
• He shows that
— Optimal portfolios based on the pricing restrictions deliver the lowest Sharpe ratios.
— Completely disregarding pricing restrictions results in the second lowest Sharpe ratios.
— Much higher Sharpe ratios are obtained when asset allocation is based on the shrinkage
approach.
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7. Bayesian Asset Allocation > 7.7 Could you exploit predictability to design outperforming
trading strategies?
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7. Bayesian Asset Allocation > 7.7 Could you exploit predictability to design outperforming
trading strategies?
• They focus on the largest NYSE-AMEX firms by excluding the smallest quartile
of firms from the sample.
• They capture 3123 such firms during the July 1972 through November 2003
investment period.
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7. Bayesian Asset Allocation
> 7.7 Could you exploit predictability to design outperforming trading strategies?
> 7.7.1 The evolution of stock returns
The Evolution of Stock Returns
• The underlying statistical models for excess stock returns, the market
premium, and macro variables are
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7. Bayesian Asset Allocation
> 7.7 Could you exploit predictability to design outperforming trading strategies?
> 7.7.1 The evolution of stock returns
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7. Bayesian Asset Allocation
> 7.7 Could you exploit predictability to design outperforming trading strategies?
> 7.7.1 The evolution of stock returns
• In the end, time varying model alpha is the major source of predictability and
investment profitability focusing on individual stocks, portfolios, mutual funds,
and hedge funds.
• Time varying alpha is also the major source of predictability in mutual fund and
hedge fund investing.
• In the mutual fund and hedge fund context alpha reflects skill. Be careful here!
Alpha reflects skill only if the benchmarks used to measure performance are able
to price all passive payoffs.
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7. Bayesian Asset Allocation
> 7.7 Could you exploit predictability to design outperforming trading strategies?
> 7.7.2 The proposed trading strategy
The Proposed Trading Strategy
• Form optimal portfolios from the universe of 3123 AMEX-NYSE stocks over the
period 1972 through 2003 with monthly rebalancing on the basis of various
models for stock returns.
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7. Bayesian Asset Allocation
> 7.7 Could you exploit predictability to design outperforming trading strategies?
> 7.7.2 The proposed trading strategy
• For instance, when predictability in alpha, beta, and the equity premium is
permissible, the mean and variance used to form optimal portfolios are
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7. Bayesian Asset Allocation
> 7.7 Could you exploit predictability to design outperforming trading strategies?
> 7.7.2 The proposed trading strategy
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7. Bayesian Asset Allocation
> 7.7 Could you exploit predictability to design outperforming trading strategies?
> 7.7.3 Performance evaluation
Performance evaluation
• We implement a recursive scheme:
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7. Bayesian Asset Allocation
> 7.7 Could you exploit predictability to design outperforming trading strategies?
> 7.7.3 Performance evaluation
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
7. Bayesian Asset Allocation
> 7.7 Could you exploit predictability to design outperforming trading strategies?
> 7.7.3 Performance evaluation
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So far, we have shown
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So far, we have shown
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Exploiting predictability in mutual fund returns
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Exploiting predictability in mutual fund returns
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The Dogmatist . The Skeptic . The Agnostic . .
ND PD-1 PD-2 NS PS-1 PS-2 PS-3 PS-4 NA PA-1 PA-2 PA-3 PA-4 H-H CAR SM
𝜇 6.39 6.58 6.74 6.92 5.56 6.06 15.14 11.5 7.07 5.26 5.89 16.52 12.12 8.97 5.42 5.78
𝑠𝑡𝑑 0.16 0.16 0.16 0.21 0.21 0.18 0.28 0.21 0.21 0.21 0.18 0.28 0.22 0.2 0.19 0.17
𝑆𝑅 0.39 0.41 0.43 0.33 0.27 0.34 0.55 0.54 0.33 0.25 0.33 0.59 0.54 0.44 0.28 0.34
𝑠𝑘𝑒𝑤 -0.71 -0.68 0.03 -0.2 -0.38 -0.28 1.13 0.32 -0.18 -0.35 -0.31 1.05 0.21 -0.52 -0.57 -0.76
𝛼𝑐𝑝𝑚 -0.23 0 1.92 -0.38 -1.89 0.71 8.12 6.48 -0.23 -2.16 0.54 9.46 6.73 1.95 -1.86 -0.99
𝑃 𝛼𝑐𝑝𝑚 0.66 1 0.38 0.88 0.36 0.79 0.07 0.08 0.93 0.31 0.84 0.04 0.08 0.39 0.26 0.32
𝛼𝑓𝑓 0.6 1.03 0.91 2.33 0.29 -0.51 11.14 6.86 2.49 0.06 -0.46 12.89 7.88 3.48 -0.39 -0.17
𝑃 𝛼𝑓𝑓 0.22 0.04 0.68 0.22 0.87 0.85 0.01 0.05 0.2 0.97 0.86 0 0.03 0.04 0.74 0.81
𝛼𝑤𝑚𝑙 0.37 0.62 3.92 -1.3 -2.49 0.83 5.98 4.95 -1.29 -2.83 0.51 8.46 6.2 -0.99 -0.48 -1.1
𝑃 𝛼𝑤𝑚𝑙 0.46 0.22 0.07 0.45 0.13 0.76 0.14 0.17 0.47 0.1 0.85 0.04 0.1 0.46 0.69 0.06
𝛼 𝑐𝑝𝑚 -0.09 0.14 1.85 0.14 -1.75 0.66 9.01 6.36 0.25 -1.99 0.49 10.52 6.76 1.97 -1.5 -0.99
𝑃 𝛼𝑐𝑝𝑚 0.87 0.8 0.4 0.96 0.4 0.8 0.05 0.08 0.92 0.35 0.85 0.02 0.08 0.39 0.35 0.32
𝛼𝑓𝑓 0.2 0.84 0.91 2.96 1.02 0.29 13.3 9.28 3.1 1.03 0.65 14.84 9.13 4.45 0.3 0.29
𝑃 𝛼𝑓𝑓 0.64 0.05 0.62 0.12 0.55 0.9 0 0.01 0.11 0.56 0.79 0 0.01 0 0.79 0.67
𝛼𝑤𝑚𝑙 0.24 0.69 1.9 -0.84 -1.99 -0.37 9.44 7.88 -0.78 -2.01 -0.19 11.17 7.28 0.08 -0.57 -1.05
𝑃 𝛼𝑤𝑚𝑙 0.59 0.12 0.3 0.61 0.23 0.88 0.02 0.03 0.65 0.24 0.94 0 0.05 0.95 0.61321 0.08
Downside Risk
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8. Downside Risk Measures
Downside Risk
• Downside risk is the financial risk associated with losses.
• That is, volatility treats symmetrically up and down moves (relative to the
mean).
• Or volatility is about the entire distribution while down side risk concentrates
on the left tail.
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8. Downside Risk Measures
Downside Risk
• Example of downside risk measures
— Expected Shortfall
— Semi-variance
— Maximum drawdown
— Downside Beta
— Shortfall probability
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8. Downside Risk Measures
• More generally,
PrR VaR1
5%
VaR95%
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8. Downside Risk Measures
326
8. Downside Risk Measures
If
R ~ N , 2
Then Pr R VaR1 Pr R VaR
R 1.64
Pr
Pr z 1.64 1.64 0.05
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8. Downside Risk Measures
•
Suppose: R ~ N 0.08,0.202
VaR0.95 0.08 1.64 0.20 0.25
• That is to say that we are 95% sure that the future equity
premium won’t decline more than 25%.
• If we would like to be 97.5% sure – the price is that the
threshold loss is higher.
• To illustrate,
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8. Downside Risk Measures
VaR of a Portfolio
• Evidently, the VaR of a portfolio is not necessarily lower than the combination
of individual VaR-s – which is apparently at odds with the notion of
diversification.
• However, recall that VaR is a downside risk measure while volatility which
diminishes at the portfolio level is a symmetric measure.
329
8. Downside Risk Measures
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8. Downside Risk Measures
• Use the first, say, sixty monthly observations to estimate the mean and
volatility and compute the VaR.
331
8. Downside Risk Measures
• Suppose we get 5.5% of the time – is it a bad model or just a bad luck?
332
8. Downside Risk Measures
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8. Downside Risk Measures
334
8. Downside Risk Measures
y x
f x P0 1 P0
yx
x
335
8. Downside Risk Measures
E x P0 y
VaR x P0 1 P0 y
Thus
x P0 y
Z ~ N 0,1
P0 1 P0 y
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8. Downside Risk Measures
H 0 : x 12.6 20 12.6
Z 2.14
H1 : Otherwise 0.05 0.95 252
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8. Downside Risk Measures
• They did find out that the problem was that the actual revenue departed
from the normal distribution.
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8. Downside Risk Measures
• The ES is formulated as
339
8. Downside Risk Measures
R ~ N , 2
ES1 E R | R 1
1
ES1
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8. Downside Risk Measures
341
8. Downside Risk Measures
x ~ N , 2
0 1
E x | x VaR1
0
since
VaR1
0 1
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8. Downside Risk Measures
8%
20%
1.64 0.10
ES 95% 0.08 0.20 0.08 0.20 0.32
0.05 0.05
1.96 0.06
ES 97.5% 0.08 0.20 0.08 0.20 0.40
0.025 0.25
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8. Downside Risk Measures
• Why?
• The first lower figures (VaR) are unconditional in nature relying on the entire
distribution.
344
8. Downside Risk Measures
345
8. Downside Risk Measures
• Just look at the expression for ES under normality to quickly realize that you
need to minimize the volatility of the portfolio subject to an expected return
target.
346
8. Downside Risk Measures
h E min r h,02
• where h is some target level.
• For instance, h Rf
• Unlike the variance, E r
2 2
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8. Downside Risk Measures
348
8. Downside Risk Measures
• Useful for an investor who does not know the entry/exit point
and is concerned about the worst outcome.
350
8. Downside Risk Measures
Downside Beta
• I will introduce three distinct measures of downsize beta – each
of which is valid and captures the down side of investment
payoffs.
351
8. Downside Risk Measures
Downside Beta
E Ri R f min( R R ,0)
(1)
m f
E min( R R ,0)
im 2
m f
352
8. Downside Risk Measures
Downside Beta
E Ri i min Rm m ,0
( 2)
E min Rm m ,0
im 2
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9. Estimating & Evaluating Asset Pricing Models
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9. Estimating & Evaluating Asset Pricing Models > 9.1. Why Caring About Asset Pricing Models
• For instance, in the single factor CAPM the market beta – or the
co-variation with the market – characterizes the systematic risk of
the firm.
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𝑉 −1 𝜇𝑒
𝑤𝑇𝑃 = (9.1/1)
𝜄′ 𝑉 −1 𝜇𝑒
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𝜇𝑒 = 𝛽𝜇𝑚
𝑒 (9.1/2)
𝑉 = 𝛽𝛽′ 𝜎𝑚
2
+ Σ (9.1/3)
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9. Estimating & Evaluating Asset Pricing Models > 9.1. Why Caring About Asset Pricing Models
2 –Asset Allocation
• The corresponding quantities under the FF model are
𝜇𝑒 = 𝛽𝑀𝐾𝑇 𝜇𝑚 𝑒 +𝛽
𝑆𝑀𝐿 𝜇𝑆𝑀𝐿 + 𝛽𝐻𝑀𝐿 𝜇𝐻𝑀𝐿
(9.1.4)
𝑉 = 𝛽 𝐹 𝛽′ +
where 𝐹 is the covariance matrix of the factors.
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9. Estimating & Evaluating Asset Pricing Models > 9.1. Why Caring About Asset Pricing Models
3 – Discount Factor
• Expected return is the discount factor, commonly denoted by k,
in present value formulas in general and firm evaluation in
particular:
𝑇 𝐶𝐹𝑡
𝑃𝑉 = 𝑡=1 1+𝑘 𝑡 (9.1/5)
• In practical applications, expected returns are typically assumed
to be constant over time, an unrealistic assumption.
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9. Estimating & Evaluating Asset Pricing Models > 9.1. Why Caring About Asset Pricing Models
3 – Discount Factor
• Indeed, thus far we have examined models with constant beta
and constant risk premiums
𝜇𝑒 = 𝛽′ 𝜆 (9.1/6)
• When factors are return spreads the risk premium is the mean of
the factor.
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9. Estimating & Evaluating Asset Pricing Models > 9.1. Why Caring About Asset Pricing Models
4 - Benchmarks
• Factors in asset pricing models serve as benchmarks for
evaluating performance of active investments.
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5 - Corporate Finance
• There is a plethora of studies in corporate finance that use asset
pricing models to risk adjust asset returns.
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9. Estimating & Evaluating Asset Pricing Models > 9.1. Why Caring About Asset Pricing Models
5 - Corporate Finance
• Analyzing mergers and acquisitions
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9. Estimating and Evaluating Asset Pricing Models > 9.2 Time-Series Regressions
– Likelihood Ratio;
– GMM.
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9. Estimating and Evaluating Asset Pricing Models > 9.2 Time-Series Regressions
The Distribution of α
• Recall, 𝑎 is asset mispricing.
• The time series regressions can be rewritten using a vector form
as:
𝑟𝑡𝑒 = α + β ⋅ 𝑟𝑚𝑡 𝑒
+ 𝜀𝑡
𝑁𝑋1 𝑁𝑋1 𝑁𝑋1 1𝑋1 𝑁𝑋1
for 𝑡 = 1,2,3, … , 𝑇
• Let Θ = 𝛼′, 𝛽′, 𝑣𝑒𝑐ℎ 𝜀 ′ ′ be the set of all parameters.
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1
−2 1
𝐿 𝜀𝑡 |𝜃 = 𝑐 exp − 𝑟𝑡𝑒 − 𝛼 − 𝛽 𝑟𝑚𝑡
𝑒
′ −1 𝑟𝑡𝑒 − 𝛼 − 𝛽 𝑟𝑚𝑡
𝑒
(9.2/1)
2
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9. Estimating and Evaluating Asset Pricing Models > 9.2 Time-Series Regressions
Asymptotically, we have 𝜃 − 𝜃 ~𝑁 0, 𝜃
where
−1
ln2 𝛼
Σ 𝜃 = −𝐸 𝜕𝜃𝜕𝜃′
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𝛼 = 𝜇 𝑒 − 𝛽 ⋅ 𝜇𝑚
𝑒
𝑇
𝑡=1 𝑟𝑡𝑒 − 𝜇 𝑒 𝑟𝑚𝑡
𝑒 𝑒
− 𝜇𝑚
𝛽= 𝑇 𝑒 𝑒 2
𝑟
𝑡=1 𝑚𝑡 − 𝜇 𝑚
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.2 Time-Series Regressions
Moreover,
𝑇
1
= 𝜀𝑡 𝜀𝑡′
𝑇
𝑡=1
𝑇
1
𝜇𝑒 = 𝑟𝑡𝑒
𝑇
𝑡=1
𝑇
𝑒
1 𝑒
𝜇𝑚 = 𝑟𝑚𝑡
𝑇
𝑡=1
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9. Estimating and Evaluating Asset Pricing Models > 9.2 Time-Series Regressions
The Distribution of α
• We get:
𝑒 2
1 𝜇𝑚
𝛼 ~𝑁 𝛼, 1 + Σ
𝑇 𝜎 𝑚
• Moreover,
1 1
𝛽 ~𝑁 𝛽, ⋅ 2 Σ
𝑇 𝜎𝑚
𝑇 ~ 𝑇 − 2, Σ
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9. Estimating and Evaluating Asset Pricing Models > 9.2 Time-Series Regressions
• Here we test
𝐻0 : 𝛼 = 0
𝐻1 : 𝛼 ≠ 0
where
𝐻0
𝛼 ∼ 𝑁 0, Σ𝛼
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which becomes:
𝑒 2 −1 ′ −1
𝜇𝑚 𝛼 𝛼
𝐽1 = 𝑇 1 + 𝛼′ −1
𝛼=𝑇 2
𝜎𝑚 1 + 𝑆𝑅𝑚
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𝑒
𝑟𝑡𝑒 = 𝑋 θ1 + ε1 1, 𝑟𝑚1
𝑇𝑥1 𝑇𝑥2 2𝑥1 𝑇𝑥1
𝑋 = ⋮
⋮ where 𝑇𝑥2 𝑒
1, 𝑟𝑚𝑇
𝑟𝑁𝑒 = 𝑋 θ𝑁 + ε𝑁
𝑇𝑥1 𝑇𝑥2 2𝑥1 𝑇𝑥1 𝜃𝑖 = 𝛼𝑖 , 𝛽𝑖 ′
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9. Estimating and Evaluating Asset Pricing Models > 9.2 Time-Series Regressions
The LR Test
𝑇
𝐿𝑅 = ln 𝐿∗
− ln 𝐿 = − ln ∗ − ln
2
𝐽2 = −2𝐿𝑅 = 𝑇 ln ∗ − ln ∼ 𝜒2 𝑁
• Thus,
𝐽1
𝐽2 = 𝑇 ⋅ ln +1
𝑇
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9. Estimating and Evaluating Asset Pricing Models > 9.2 Time-Series Regressions
GRS (1989)
Theorem: let
∼ 𝑁 0, Σ
𝑁𝑥1
let
A ~ W 𝜏, Σ
𝑁𝑥1
where 𝜏 ≥ 𝑁
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9. Estimating and Evaluating Asset Pricing Models > 9.2 Time-Series Regressions
• In our context:
1
2 −2
𝜇𝑚 𝐻
𝑋 = 𝑇 1+ 𝛼 ∼0 𝑁 0, Σ
𝜎𝑚
𝐴 = 𝑇Σ ∼ 𝑊 𝜏, Σ
where
𝜏 =𝑇−2
• Then:
2 −1
𝑇−𝑁−1 𝜇𝑚
𝐽3 = 1+ 𝛼 ′ Σ −1 𝛼 ∼ 𝐹 𝑁, 𝑇 − 𝑁 − 1
𝑁 𝜇 𝜎𝑚
GMM
I will directly give the statistic (derivation comes up later
in the notes)
𝐻0
𝐽4 = 𝑇𝛼 ′ (𝑅(𝐷𝑇 ′ 𝑆𝑇−1 𝐷𝑇 )−1 𝑅′ )−1 ⋅ 𝛼 ∼ 𝜒 2 (𝑁)
where
R = IN , 0
𝑁𝑥2𝑁 𝑁𝑥𝑁 𝑁𝑥𝑁
1, 𝜇𝑚𝑒
𝐷𝑇 = − 𝑒 𝑒 2 2 ⨂𝐼𝑁
𝜇𝑚 , 𝜇𝑚 + 𝜎𝑚
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9. Estimating and Evaluating Asset Pricing Models > 9.2 Time-Series Regressions
where
𝑒 ′
𝑥𝑡 = [1, 𝑟𝑚𝑡 ]
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9. Estimating and Evaluating Asset Pricing Models > 9.2 Time-Series Regressions
2,𝜎
𝜎𝑚
𝑒
𝜇𝑚 𝑚,𝑆𝑀𝐵 , 𝜎𝑚,𝐻𝑀𝐿
2
𝜇𝐹 = 𝜇𝑆𝑀𝐵 Σ𝐹 = 𝜎𝑆𝑀𝐵,𝑚 , 𝜎𝑆𝑀𝐵 , 𝜎𝑆𝑀𝐵,𝐻𝑀𝐿
𝜇𝐻𝑀𝐿 2
𝜎𝐻𝑀𝐿,𝑚 , 𝜎𝐻𝑀𝐿,𝑆𝑀𝐵, 𝜎𝐻𝑀𝐿
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𝛼 Σ −1 𝛼
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9. Estimating and Evaluating Asset Pricing Models > 9.2 Time-Series Regressions
−1
Understanding the Quantity 𝛼 ′ 𝛼
• Consider an investment universe that consists of 𝑁 + 1 assets -
the 𝑁 test assets as well as the market portfolio.
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−1
Understanding the Quantity 𝛼 ′ 𝛼
• The variance covariance matrix of the N+1 assets is given by
𝜎𝑚2, 𝛽′ 𝜎𝑚
2
Φ = 2,
𝑁+1 × 𝑁+1 𝛽𝜎𝑚 𝑉
where
2 is the estimated variance of the market factor.
𝜎𝑚
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−1
Understanding the Quantity 𝛼 ′ 𝛼
• Notice that the covariance matrix of the N test assets is
𝑉 = 𝛽 𝛽 ′ 𝜎𝑚
2 +Σ
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−1
Understanding the Quantity 𝛼 ′ 𝛼
• Notice also that the inverse of the covariance
matrix is
2 −1
𝜎𝑚 + 𝛽 ′ Σ−1 𝛽, −𝛽 ′ Σ−1
Φ−1 =
−Σ−1 𝛽 , Σ−1
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−1
Understanding the Quantity 𝛼 ′ 𝛼
𝑒 2
2 𝜇𝑚 𝑒 𝑒 ′ −1
𝑆𝑅𝑇𝑃 = + 𝜇 − 𝛽 𝜇𝑚 Σ 𝜇𝑒 − 𝛽 𝜇𝑚
𝑒
𝜎𝑚
2 2
𝑆𝑅𝑇𝑃 = 𝑆𝑅𝑚 + 𝛼 ′ Σ−1 𝛼
or
2
𝛼 ′ Σ−1 𝛼 = 𝑆𝑅𝑇𝑃 − 𝑆𝑅𝑚 2
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−1
Understanding the Quantity 𝛼 ′ 𝛼
• In words, the 𝛼 ′ Σ −1 𝛼 quantity is the difference between the
squared Sharpe ratio based on the 𝑁 + 1 assets and the squared
Sharpe ratio of the market portfolio.
• If the CAPM is correct then these two Sharpe ratios are identical
in population, but not identical in sample due to estimation
errors.
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−1
Understanding the Quantity 𝛼 ′ 𝛼
• The test statistic examines how close the two
sample Sharpe ratios are.
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−1
Understanding the Quantity 𝛼 ′ 𝛼
𝑟
𝑇𝑃
𝑀
Φ2
𝑅𝑓
Φ1
−1
Understanding the Quantity 𝛼 ′ 𝛼
• So we can rewrite the previously derived test statistics
as
2 2
𝑆𝑅𝑇𝑃 − 𝑆𝑅𝑚 2
𝐽1 = 𝑇 2
~𝜒 𝑁
1 + 𝑆𝑅𝑚
2 2
𝑇 − 𝑁 − 1 𝑆𝑅𝑇𝑃 − 𝑆𝑅𝑚
𝐽3 = × 2
~𝐹 𝑁, 𝑇 − 𝑁 − 1
𝑁 1 + 𝑆𝑅𝑚
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• But even if the model is correct, this plot will not work out
perfectly well because of sampling errors.
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𝑟𝑖 = 𝛽𝑖 ′ 𝜆 + 𝜈𝑖 . (9.3/2)
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𝜈 = 𝑟 − 𝜆𝛽. (9.3/4)
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9. Estimating and Evaluating Asset Pricing Models > 9.3 Cross Sectional Regressions
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.3 Cross Sectional Regressions
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.3 Cross Sectional Regressions
• Under this assumption he shows that the standard errors based on the cross
sectional procedure overstate the precision of the estimated parameters.
2 1
𝜎𝑒𝑖𝑣 (𝜆) = 𝜎 2 (𝜆)ϒ + 𝑇 Ω𝑓 (9.3/9)
• Of course, if factors are return spreads then 𝜆′ Ω𝑓−1 𝜆 is the squared Sharpe
ratio attributable to a mean-variance efficient investment in the factors.
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9. Estimating and Evaluating Asset Pricing Models > 9.4 Fama and MacBeth (FM) Procedure
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9. Estimating and Evaluating Asset Pricing Models > 9.4 Fama and MacBeth (FM) Procedure
𝛿𝑡 = (𝑋 ′ 𝑋)−1 𝑋 ′ 𝑟𝑡 , (9.4/2)
1 𝑇
𝜖𝑖 = 𝑡=1 𝜖𝑖,𝑡 . (9.4/5)
𝑇
1 𝑇 2
𝜎 2 (𝛿 ) = 𝑡=1 𝛿𝑡 − 𝛿 , (9.4/6)
𝑇2
1 𝑇 2
𝜎 2 (𝜖𝑖 ) = 𝑡=1 𝜖𝑖,𝑡 − 𝜖𝑖 . (9.4/7)
𝑇2
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.4 Fama and MacBeth (FM) Procedure
• Then we can test whether all pricing errors are zero using the test
statistic (6.2/7).
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.5 Beta Pricing versus the Discount
Factor Representation
The SDF Approach
• The absence of arbitrage in a dynamic economy guarantees the
existence of a strictly positive discount factor that prices all
traded assets [see Harisson and Kreps (1979)].
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.5 Beta Pricing versus the Discount
Factor Representation
• The fundamental pricing equation (9.5/1) holds for any asset either stock,
bond, option, or real investment opportunity.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.5 Beta Pricing versus the Discount
Factor Representation
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9. Estimating and Evaluating Asset Pricing Models > 9.5 Beta Pricing versus the Discount
Factor Representation >9.5.2 Is The Pricing Kernel Linear or nonlinear in the factors?
Is the pricing Kernel linear or nonlinear in the factors?
• In a single-period economy the pricing kernel is given by
𝑈 ′ (𝑊𝑡+1 )
𝜉𝑡+1 = . (9.5.2/1)
𝑈 ′ (𝑊𝑡 )
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.5 Beta Pricing versus the Discount
Factor Representation >9.5.2 Is The Pricing Kernel Linear or nonlinear in the factors?
𝑊𝑡 𝑈 ′′ (𝑊𝑡 )
𝜉𝑡+1 = 1 + ′ 𝑟𝑤,𝑡+1 + 𝑜(𝑊𝑡 ), (9.5.2/2)
𝑈 (𝑊𝑡 )
= 𝑎 + 𝑏𝑟𝑤,𝑡+1 , (9.5.2/3)
where 𝑎 = 1 + 𝑜(𝑊𝑡 ) and 𝑏 is the negative relative risk aversion
coefficient.
• This first order approximation results in the traditional CAPM.
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9. Estimating and Evaluating Asset Pricing Models > 9.5 Beta Pricing versus the Discount
Factor Representation >9.5.2 Is The Pricing Kernel Linear or nonlinear in the factors?
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.5 Beta Pricing versus the Discount
Factor Representation > 9.5.3 Are pricing kernel parameters fixed or time-varying?
Are pricing kernel parameters fixed or time-varying?
1−𝛾
𝑐𝑡
• Let us start with preferences represented by 𝑈(𝑐𝑡 ) = .
1−𝛾
𝑈 ′ (𝑐𝑡+1 )
• Take Taylor’s series expansion of the pricing kernel 𝜌 ′
𝑈 (𝑐𝑡 )
around 𝑈 ′ (𝑐𝑡 ) and obtain
= 𝑎 + 𝑏Δ𝑐𝑡+1 . (9.5.3/2)
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.5 Beta Pricing versus the Discount
Factor Representation > 9.5.3 Are pricing kernel parameters fixed or time-varying?
427
ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.5 Beta Pricing versus the Discount
Factor Representation > 9.5.3 Are pricing kernel parameters fixed or time-varying?
428
ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.5 Beta Pricing versus the Discount
Factor Representation > 9.5.3 Are pricing kernel parameters fixed or time-varying?
430
ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
Should a Rejected CAPM be Abandoned?
• Not necessarily!
𝜇𝑖 = 𝛼𝑖 + 𝑅𝑓 + 𝛽𝑖 𝜇𝑚 − 𝑅𝑓 where 𝛼𝑖 ≠ 0
1 1 𝑇
𝜇𝑖 = 𝑡=1 𝑅𝑖𝑡
𝑇
2
𝜇𝑖 = 𝑅𝑓 + 𝛽𝑖 𝜇𝑚 − 𝑅𝑓
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
Mean Standard Error (MSE)
• The quality of estimates is evaluated based on the Mean Squared
Error (MSE)
2
1 1
𝑀𝑆𝐸 = 𝐸 𝜇𝑖 − 𝜇𝑖
2
2 2
𝑀𝑆𝐸 = 𝐸 𝜇𝑖 − 𝜇𝑖
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
MSE Bias and Noise of Estimates
• Notice that 𝑀𝑆𝐸 = 𝑏𝑖𝑎𝑠 2 + 𝑉𝑎𝑟 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
The Bias – Variance Tradeoff
• It might be the case that 𝑉𝑎𝑟 𝜇 2 is significantly lower
than 𝑉𝑎𝑟 𝜇 1 - thus even when the CAPM is rejected,
still zeroing out 𝛼𝑖 could produce a smaller mean square
error.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
When is The Rejected CAPM Superior?
1 1 2 1 2 2
𝑉𝑎𝑟 𝜇𝑖 = 𝜎 𝑅𝑖 = 𝛽𝑖 𝜎 𝑅𝑚 + 𝜎 2 𝜀𝑖
𝑇 𝑇
2 𝑒
𝑉𝑎𝑟 𝜇𝑖 = 𝑉𝑎𝑟 𝛽𝑖 𝜇𝑚
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
When is The Rejected CAPM Superior?
Using variance decomposition
2 𝑒 = 𝐸 𝑉𝑎𝑟 𝛽 𝜇 𝑒 |𝜇 𝑒 𝑒 |𝜇 𝑒
𝑉𝑎𝑟 𝜇𝑖 = 𝑉𝑎𝑟 𝛽𝑖 𝜇𝑚 𝑖 𝑚 𝑚 + 𝑉𝑎𝑟 𝐸 𝛽𝑖 𝜇𝑚 𝑚
𝜎2 𝜀𝑖 1 1 2 𝑒 2
𝜇𝑚 2
𝜎
=𝐸 𝑒
𝜇𝑚 2
2 ⋅ + 𝑉𝑎𝑟 𝑒
𝛽𝑖 𝜇𝑚 = 𝜎 𝜀𝑖 𝐸 2 + 𝛽𝑖2 𝑚
𝜎𝑚 𝑇 𝑇 𝜎𝑚 𝑇
1
= 𝑆𝑅𝑚 𝜎 2 𝜀𝑖 + 𝛽𝑖2 𝜎𝑚
2
𝑇
where
𝑒 2
𝜇𝑚
𝑆𝑅𝑚 = 𝐸 2
𝜎𝑚
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
When is The Rejected CAPM Superior?
• Then
2
𝑉𝑎𝑟 𝜇𝑖 𝑆𝑅𝑚 𝜎 2 𝜀𝑖 + 𝛽𝑖2 𝜎𝑚
2
2 2
= = 𝑆𝑅𝑚 1 − 𝑅 + 𝑅
𝑉𝑎𝑟 𝜇𝑖
1 𝜎 2 𝑅𝑖
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
Example
• Let
𝜎 2 𝑅𝑖 = 0.01
𝑒 2
𝜇𝑚
𝐸 = 0.05
𝜎𝑚
𝑅2 = 0.3
• For what values of 𝛼𝑖 ≠ 0 it is sill preferred to use the CAPM?
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
Example
2 2
𝑀𝑆𝐸 2 2
𝛼 𝑖
1
= 𝑆𝑅𝑚 1 − 𝑅 + 𝑅 + 1
<1
𝑀𝑆𝐸 𝑀𝑆𝐸
𝛼𝑖2
0.05 × 0.7 + 0.3 + <1
1
⋅ 0.01
60
2 1
𝛼𝑖 < ⋅ 0.01 × 0.665
60
𝛼𝑖 < 0.01528 = 1.528%
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.1 Overview
GMM
• We can test finance theories by the GMM of Hansen
(1982).
• Let us describe the basic concepts of GMM and propose
some applications.
• Let Θ be an 𝑚 × 1 vector of parameters to be estimated
from a sample of observations 𝑥1 , 𝑥2 , … , 𝑥𝑇 .
• Our conditional beta factor model does not have that
unconditional multifactor interpretation since the firm-
level 𝑆𝑖𝑧𝑒𝑗 and 𝐵𝑀𝑗 are not common across all test
assets.
440
ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.1 Overview
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.1 Overview
• First, it may not make efficient use of all the information in the
sample.
442
ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.1 Overview
• In this case one could find the GMM estimate Θ, which satisfies
𝐸 𝑓𝑡 (Θ) = 0. (9.6.1/1)
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.1 Overview
1 𝑇
𝑔𝑇 (Θ) = 𝑡=1 𝑓𝑡 (Θ). (9.6.1/2)
𝑇
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.1 Overview
1 𝑇
𝑔𝑇 (Θ) = 𝑡=1 𝑓𝑡 (Θ) = 0. (9.6.1/3)
𝑇
445
ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.1 Overview
where
• Observe from (9.6.1/7) that the left (and obviously the right) hand side is an
𝑚 × 1 vector. Therefore, as 𝑟 > 𝑚 only a linear combination of the moments,
given by 𝐷𝑇 (Θ)′ 𝑊𝑇 , is set to zero.
446
ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.1 Overview
• Hansen (1982, theorem 3.1) tells us the asymptotic distribution of the GMM
estimate is
where
∞
= 𝑗=−∞ 𝐸 𝑓𝑡 (Θ)𝑓𝑡−𝑗 (Θ)′ , (9.6.1/11)
• To implement the GMM one would like to replace 𝑆 with its sample estimate.
447
ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.1 Overview
1 𝑇
𝑆𝑇 = 𝑡=1 𝑓𝑡 (Θ)𝑓𝑡 (Θ)′ . (9.6.1/13)
𝑇
• We have not yet addressed the issue of how to choose the optimal weighting
matrix.
𝑉 ∗ = 𝐷0 ′ 𝑆 −1 𝐷0 −1
. (9.6.1/14)
448
ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.1 Overview
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.1 Overview
• Thus, the test statistic in (9.6.1/15) can be expressed as the minimized value
of the model errors (in asset pricing context pricing errors) weighted by their
covariance matrix
−1
𝑔𝑇 (Θ)′ 𝑣𝑎𝑟 𝑔𝑇 (Θ) 2
𝑔𝑇 (Θ) ∼ 𝜒𝑟−𝑚 . (9.6.1/16)
• The work of Hansen and Singleton (1982, 1983) is, to my knowledge, the
first to apply the GMM in general and in the context of asset pricing in
particular.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM
> 9.6.2 Application# 1: Estimating the mean of a time series
Application# 1: Estimating the mean of a time series
• You observe 𝑥1 , 𝑥2 , … , 𝑥𝑇 and want to estimate the sample mean.
451
ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM
> 9.6.2 Application# 1: Estimating the mean of a time series
• Notice that
1 𝑇
𝑔𝑇 (Θ) = 𝑡=1( 𝑥𝑡 − 𝜇). (9.6.2/2)
𝑇
• Setting
𝑔𝑇 (Θ) = 0. (9.6.2/3)
1 𝑇
𝜇= 𝑡=1 𝑥𝑡 . (9.6.2/4)
𝑇
452
ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM
> 9.6.2 Application# 1: Estimating the mean of a time series
• estimated using
1 𝑇 1 𝑇
𝑆𝑇 = 𝑡=1 𝑓𝑡 (Θ)𝑓𝑡 (Θ)′ = 𝑡=1( 𝑥𝑡 − 𝜇)2 (9.6.2/6)
𝑇 𝑇
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM
> 9.6.2 Application# 1: Estimating the mean of a time series
• Asymptotically
1
𝜇 ∼ 𝑁 𝜇, 𝑉 .
𝑇
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM> 9.6.3 Application # 2: Estimating
the market model coefficients when the residuals are heteroskedastic and serially uncorrelated
455
ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM> 9.6.3 Application # 2: Estimating
the market model coefficients when the residuals are heteroskedastic and serially uncorrelated
456
ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM> 9.6.3 Application # 2: Estimating
the market model coefficients when the residuals are heteroskedastic and serially uncorrelated
where
𝑟𝑡 = 𝑟𝑖,𝑡 , (9.6.3/4)
𝑥𝑡 = [1, 𝑟𝑚,𝑡 ]′ , (9.6.3/5)
𝜖𝑡 = 𝜖𝑖,𝑡 , (9.6.3/6)
𝛽 = [𝛼𝑖 , 𝛽𝑖 ]′ . (9.6.3/7)
• Let us now compute the sample moment
1 𝑇
𝑔𝑇 (Θ) = 𝑡=1 𝑥𝑡 (𝑟𝑡 − 𝑥𝑡 ′ 𝛽). (9.6.3/8)
𝑇
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM> 9.6.3 Application # 2: Estimating
the market model coefficients when the residuals are heteroskedastic and serially uncorrelated
= 𝑋′𝑋 −1 𝑋 ′ 𝑅, (9.6.3/10)
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM> 9.6.3 Application # 2: Estimating
the market model coefficients when the residuals are heteroskedastic and serially uncorrelated
459
ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM> 9.6.3 Application # 2: Estimating
the market model coefficients when the residuals are heteroskedastic and serially uncorrelated
estimated by
1
𝑉𝑎𝑟(𝛽) = 𝐷𝑇 ′ 𝑆𝑇−1 𝐷𝑇 −1
, (9.6.3/17)
𝑇
𝑇
= (𝑋 ′ 𝑋)−1 𝑡=1 𝑥𝑡 𝑥𝑡 ′ 𝜖𝑡2 (𝑋 ′ 𝑋)−1 . (9.6.3/18)
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.4 Application # 3: Testing
the CAPM
Application # 3: Testing the CAPM
• Here, we derive the CAPM test described on pages 208-210 in
Campbell, Lo, and MacKinlay.
𝑟𝑡𝑒 = 𝛼 + 𝛽𝑟𝑚𝑡
𝑒
+ 𝜖𝑡 . (6.5.4/1)
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.4 Application # 3: Testing
the CAPM
1(26) 𝜖𝑡 (27)
𝑓𝑡 (Θ) = 𝑥𝑡 ⊗ 𝜖𝑡 = 𝑒 ⊗ 𝜖𝑡 = 𝑒 , (9.6.4/2)
𝑟𝑚,𝑡 𝑟𝑚,𝑡 𝜖𝑡
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.4 Application # 3: Testing
the CAPM
2. Compute 𝐷0 .
𝜕𝑓𝑡 (𝛩)
= 𝑥𝑡 ⊗ − 𝑥𝑡 ′ ⊗ 𝐼𝑁 , (9.6.4/3)
𝜕𝛩′
𝑒
1 𝑟𝑚,𝑡 (30)
=− 𝑒 2 ⊗ 𝐼𝑁 . (9.6.4/4)
𝑟𝑚,𝑡 𝑟 𝑒 𝑚,𝑡
Moreover,
𝜕𝑔𝑇 (𝛩)
𝐷0 = 𝐸 (9.6.4/5)
𝜕𝛩′
𝜕𝑓 (𝛩)
= 𝐸 𝑡′ (9.6.4/6)
𝜕𝛩
1 𝜇𝑚 (34)
=− 2 + 𝜎 2 ⊗ 𝐼𝑁 , (9.6.4/7)
𝜇𝑚 𝜇𝑚 𝑚
where 𝜇𝑚 2 = 𝑣𝑎𝑟(𝑟
= 𝐸(𝑟𝑚,𝑡 ) and 𝜎𝑚 𝑚,𝑡 ).
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.4 Application # 3: Testing
the CAPM
4. That is,
1 𝜇𝑚 (36)
𝐷𝑇 = − 2 2 ⊗ 𝐼𝑁 , (9.6.4/8)
𝜇𝑚 𝜇𝑚 + 𝜎𝑚
6. Still, you can test the CAPM since you only focus on the model
restriction 𝛼 = 0.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.4 Application # 3: Testing
the CAPM
1 𝑇
= 𝑡=1( 𝑥𝑡 ⊗ 𝜖𝑡 ). (9.6.4/10)
𝑇
The GMM estimator Θ satisfies 𝑔𝑇 Θ = 0
1 𝑇
𝑡=1 𝑥𝑡 ⊗ 𝜖𝑡 = 0 (9.6.4/11)
𝑇
1 𝑇
𝑡=1 𝑥𝑡 ⊗ 𝑟𝑡 − (𝑥𝑡 ′ ⊗ 𝐼𝑁 )Θ =0 (9.6..4/12)
𝑇
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9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.4 Application # 3: Testing
the CAPM
1 𝑇 𝑇 1
𝑥𝑡 ⊗ 𝑟𝑡 =
𝑡=1 𝑡=1 ( 𝑥𝑡 ⊗ 𝑥𝑡 ′ ⊗ 𝐼𝑁 )Θ (9.6.4/13)
𝑇 𝑇
The GMM estimator is thus given by
−1
1 𝜇𝑚 𝜇
Θ= 2 + 𝜎2 ⊗ 𝐼𝑁 ,
𝜇𝑚 𝜇𝑚 𝑚 𝜎𝑟𝑚 + 𝜇 𝜇𝑚
2 + 𝜎2
𝜇𝑚 −𝜇𝑚 𝜇
1 𝑚
= ⊗ 𝐼𝑁 ,
2
𝜎𝑚 −𝜇𝑚 1 𝜎𝑟𝑚 + 𝜇𝜇𝑚
𝜎𝑟𝑚
𝜇− 2 𝜇𝑚 𝛼
𝜎𝑚
= = . (9.6.4/14)
𝜎𝑟𝑚 𝛽
𝜎𝑚2
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9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.4 Application # 3: Testing
the CAPM
1
= 𝑇
𝑡=1 𝑥𝑡 𝑥𝑡 ′ ⊗ 𝜖𝑡 𝜖𝑡 ′ (9.6.4/16)
𝑇
9. Given 𝑆𝑇 and 𝐷𝑇 compute 𝑉𝑇 the sample estimate of the optimal
variance matrix
𝑉𝑇 = 𝐷𝑇 ′ 𝑆𝑇−1 𝐷𝑇 −1 (9.6.4/17)
10. The asymptotic distribution of Θ is given by
𝛼 𝛼 1
Θ= ∼𝑁 𝛽 , 𝑉 , (9.6.4/18)
𝛽 𝑇
so you should substitute 𝑉𝑇 for 𝑉.
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9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.4 Application # 3: Testing
the CAPM
11. Now, we can derive the test statistic. In particular, let 𝛼 = 𝑅Θ where
𝑅 = [𝐼𝑁 , 0𝑁 ] and note that under the null hypothesis ℋ0 : 𝛼 = 0 the
asymptotic distribution of 𝑅Θ is given by
1
𝑅Θ ∼ 𝑁 0, 𝑅( 𝑉)𝑅′ . (9.6.4/19)
𝑇
The statistic 𝐽7 in CLM is derived using the Wald statistic
1 −1
𝐽7 = Θ′ 𝑅′ 𝑅( 𝑉𝑇 )𝑅 ′ 𝑅Θ, (9.6.4/20)
𝑇
= 𝑇𝛼 ′ 𝑅(𝐷𝑇 ′ 𝑆𝑇−1 𝐷𝑇 )−1 𝑅′ 𝛼.
(6.5.4/21)
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9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.4 Application # 3: Testing
the CAPM
• It should be noted that if the regression errors are both serially uncorrelated
and homoscedastic then the matrix 𝑆𝑇 in (9.6.4/16) is
1 ′ 1 𝜇𝑚 (55)
(𝑋 𝑋) ⊗Σ= 2 + 𝜎2 ⊗ Σ (9.6.4/22)
𝑇 𝜇𝑚 𝜇𝑚 𝑚
• So, the GMM test statistic is a generalized version of Wald correcting for
heteroscedasticity.
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9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.5 Application # 4: Asset
pricing tests based on over-identification
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.5 Application # 4: Asset
pricing tests based on over-identification
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.5 Application # 4: Asset
pricing tests based on over-identification
• Note that
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.5 Application # 4: Asset
pricing tests based on over-identification
• Hence, you can test the model using the 𝜒 2 over identifying test.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.6 Application # 5: Testing
return predictability over long horizon
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9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.6 Application # 5: Testing
return predictability over long horizon
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9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.6 Application # 5: Testing
return predictability over long horizon
𝑅𝑡+𝑘 − 𝛼 − 𝛽′ 𝑧𝑡 (3)
𝑓𝑡 (Θ) = . (9.6.6/5)
(𝑅𝑡+𝑘 − 𝛼 − 𝛽′ 𝑧𝑡 )𝑧𝑡 (4)
• Compute 𝐷0 :
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9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.6 Application # 5: Testing
return predictability over long horizon
∞
𝜖𝑡+𝑘 𝜖𝑡+𝑘−𝑗 𝜖𝑡+𝑘 𝜖𝑡+𝑘−𝑗 𝑧 ′ 𝑡−𝑗 (10)
𝑆= 𝑗=−∞ 𝔼 .
𝜖𝑡+𝑘 𝜖𝑡+𝑘−𝑗 𝑧𝑡 𝜖𝑡+𝑘 𝜖𝑡+𝑘−𝑗 𝑧𝑡 𝑧 ′ 𝑡−𝑗
(9.6.6/8)
• In estimating predictive regressions we scrutinize the slope coefficients only.
• And we know that
𝑇(𝛽 − 𝛽 ) ∼ 𝑁(0, 𝑉 ), (9.6.6/9)
′
where 𝑉 is the 𝑀 × 𝑀 lower-right sub-matrix of 𝑉 = 𝐷0−1 𝑆𝐷0−1 .
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9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.6 Application # 5: Testing
return predictability over long horizon
• It follows that
′
∞ 𝜇𝑧 ′ Σ𝑧−1 𝜖𝑡+𝑘 𝜖𝑡+𝑘−𝑗 𝜖𝑡+𝑘 𝜖𝑡+𝑘−𝑗 𝑧 ′ 𝑡−𝑗 𝜇𝑧 ′ Σ𝑧−1
𝑉 = 𝑗=−∞ 𝔼 ,
−Σ𝑧−1 (13) 𝜖𝑡+𝑘 𝜖𝑡+𝑘−𝑗 𝑧𝑡 𝜖𝑡+𝑘 𝜖𝑡+𝑘−𝑗 𝑧𝑡 𝑧 ′ 𝑡−𝑗 −Σ𝑧−1 (14)
= Σ𝑧−1 ∞
𝑗=−∞ 𝔼 𝛿𝑡+𝑘 𝛿𝑡+𝑘−𝑗 ′ Σ𝑧−1 ,
(9.6.6/10)
where
𝛿𝑡+𝑘 = 𝜖𝑡+𝑘 𝑧𝑡 , (9.6.6/11)
𝛿𝑡+𝑘−𝑗 = 𝜖𝑡+𝑘−𝑗 𝑧𝑡−𝑗 . (9.6.6/12)
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9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.6 Application # 5: Testing
return predictability over long horizon
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.6 Application # 5: Testing
return predictability over long horizon
• Note also that under the null 𝜎𝜖2 = 𝜎𝑟2 , where 𝜎𝑟2 is the variance
of the cumulative log return.
• Using properties of the 𝜒 2 distribution, it follows that
𝛽 ′ 𝛴𝑧 𝛽
𝑇 2 ∼ 𝜒 2 (𝑀), (9.6.6/18)
𝜎𝑟
suggesting that
𝑇𝑅2 ∼ 𝜒 2 (𝑀). (9.6.6/19)
• So we are able to derive a limiting distribution for the regression
𝑅2 .
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.6 Application # 5: Testing
return predictability over long horizon
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.7 Incorporating serial
correlation
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9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.7 Incorporating serial
correlation
𝑘 |𝑘−𝑗| 1 𝑇
𝑆= 𝑗=−𝑘 𝑘 𝑡=𝑗+1( 𝑢𝑡 − 𝑢 )(𝑢𝑡−𝑗 − 𝑢)′ ,
𝑇
(9.6.7/2)
• where 𝑢 denotes the sample mean and 𝑘 − 1 is the maximum lag length that
receives a nonzero weight.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.7 Incorporating serial
correlation
• The value 𝑘 should increase with the sample size but not too
rapidly.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 GMM > 9.6.7 Incorporating serial
correlation
𝑢𝑡 = 𝐴𝑢𝑡−1 + 𝑣𝑡 . (9.6.7/3)
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9. Estimating and Evaluating Asset Pricing Models > 9.6 The HJ Distance Measure
> 9.6.1 Motivation
• If there is only one asset, then you can compare the pricing error, i.e., the
difference between the market price of an asset and the hypothetical price
implied by a particular SDF.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 The HJ Distance Measure
> 9.6.1 Motivation
• However, when there are many assets, it is rather difficult to compare the
pricing errors across the different candidate SDFs unless pricing errors of one
SDF are always smaller across all assets.
• One simple idea would be to examine the pricing error on the portfolio (there
are infinitely many such portfolios) that is most mispriced by a given model.
• Then, the superior model is the one with the smallest pricing error.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 The HJ Distance Measure
> 9.6.1 Motivation
• Suppose there are at least two assets which do not have the same pricing
error for a given candidate SDF.
• Suppose that (i) the date 𝑡 − 1 market prices of these payoffs are both unity,
and (ii) the model assigns prices of 1 + 𝜓𝑖 , i.e., the pricing errors are 𝜓1 and
𝜓2 .
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 The HJ Distance Measure
> 9.6.1 Motivation
• That is, as long as the difference is not zero the pricing error of any portfolio of
the two assets can be arbitrarily large by adding a scale multiple of this zero-
investment portfolio.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 The HJ Distance Measure
> 9.6.2 The HJ Idea
The HJ idea
• HJ propose a way of normalization.
• They suggest examining the portfolio which has the maximum pricing errors
among all portfolio payoffs that have the unit second moments.
• Let us demonstrate.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 The HJ Distance Measure
> 9.6.2 The HJ Idea
• where
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 The HJ Distance Measure
> 9.6.2 The HJ Idea
• HJ show that the maximum pricing error per unity norm of any portfolio of
these 𝑁 assets is given by
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 The HJ Distance Measure
> 9.6.2 The HJ Idea
• We can then assess the specification error of a given stochastic discount factor
by examining the maximum pricing error 𝛿.
1 𝑇 𝜕𝑓𝑡 (𝛩) 1 𝑇 ′ 1
𝐷𝑇 = 𝑡=1 𝜕𝛩 = 𝑅 𝑌
𝑡=1 𝑡 𝑡 = 𝑅′ 𝑌, (9.6.2/6)
𝑇 𝑇 𝑇
1 𝑇
𝑔𝑇 (Θ) = 𝑡=1 𝑓𝑡 (Θ) = 𝐷𝑇 Θ − 𝜄𝑁 , (9.6.2/7)
𝑇
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 The HJ Distance Measure
> 9.6.2 The HJ Idea
1 1
𝐺𝑇 = 𝑇
𝑡=1 𝑅𝑡 𝑅𝑡 ′ = 𝑅′ 𝑅, (9.6.2/8)
𝑇 𝑇
• where
𝑅 = [𝑅1 , 𝑅2 , … , 𝑅𝑇 ]′ , (9.6.2/9)
𝑌 = [𝑌1 , 𝑌2 , … , 𝑌𝑇 ]. (9.6.2/10)
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 The HJ Distance Measure
> 9.6.2 The HJ Idea
is given by
Θ = 𝐷𝑇 ′ 𝐺𝑇−1 𝐷𝑇 −1
𝐷𝑇 ′ 𝐺𝑇−1 𝜄𝑁 , (9.6.2/14)
= 𝑇 𝑌 ′ 𝑅(𝑅′ 𝑅)−1 𝑅′ 𝑌 −1 ′
𝑌 𝑅(𝑅′ 𝑅)−1 𝜄𝑁 . (9.6.2/15)
• It follows that
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 The HJ Distance Measure
> 9.6.2 The HJ Idea
1
𝑣𝑎𝑟(Θ) = (𝐷𝑇 ′ 𝐺𝑇−1 𝐷𝑇 )−1 𝐷𝑇 ′ 𝐺𝑇−1 𝑆𝑇 𝐺𝑇−1 𝐷𝑇 (𝐷𝑇 ′ 𝐺𝑇−1 𝐷𝑇 )−1 (9.6.2/17)
𝑇
• where, if the data is serially uncorrelated, the estimate of the variance matrix
of pricing errors is given by
1 𝑇
𝑆𝑇 = 𝑡=1 𝑓𝑡 (Θ)𝑓𝑡 (Θ)′ (9.6.2/18)
𝑇
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 The HJ Distance Measure
> 9.6.2 The HJ Idea
• If the weighing matrix is optimal in the sense of Hansen (1982), then 𝑇𝛿𝑇2 is
asymptotically a random variable of 𝜒 2 distribution with 𝑁 − 𝑚 dof, where 𝑚
is the dimension of Θ.
1
𝑣𝑎𝑟(Θ) = (𝐷𝑇 ′ 𝑆𝑇−1 𝐷𝑇 )−1 . (9.6.2/19)
𝑇
However, 𝐺 is generally not optimal, and thus the distribution of 𝑇𝛿𝑇2 is not 𝜒𝑁−𝑚
2
.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 The HJ Distance Measure
> 9.6.2 The HJ Idea
𝑁−𝑚
𝑢= 𝑗=1 𝜆𝑗 𝜈𝑗 , (9.6.2/20)
• and where 𝑆 0.5 and 𝐺 0.5 are the upper-triangle matrices from the Cholesky
decomposition of 𝑆 and 𝐺.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 The HJ Distance Measure
> 9.6.2 The HJ Idea
• One can generate a large number of draws from the nonstandard distribution
(6.6.2/20) to determine the 𝑝-value of the HJ distance measure, or whether
or not it is equal to zero.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.6 The HJ Distance Measure
> 9.6.2 The HJ Idea
1 100,000
7. The empirical 𝑝-value is given by 𝑖=1 𝐼𝑖 .
100,000
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.7 Considering conditional pricing
models
Considering conditional pricing models
• Let us now demonstrate the implementation of the HJ measure when the
pricing kernel takes the form
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.7 Considering conditional pricing
models
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.7 Considering conditional pricing
models
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.7 Considering conditional pricing
models
1
𝐷𝑇 = 𝑇−1
𝑡=0 𝑅𝑡+1 ⊗ 𝑿𝑡 𝑌𝑡+1 ′ , (9.7/10)
𝑇
1 𝑇−1
𝐺𝑇 = 𝑡=0 (𝑹𝑡+1 ⊗ 𝑿𝑡 )(𝑹𝑡+1 ⊗ 𝑿𝑡 )′ . (9.7/11)
𝑇
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.7 Considering conditional pricing
models
𝑔𝑇 (Θ) = 𝐷𝑇 Θ − 𝜄𝑁 ⊗ 𝑿 , (9.7/12)
where
1 𝑇−1
𝑿= 𝑡=0 𝑿𝑡 . (9.7/14)
𝑇
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.8 HJ Measure vs. the standard GMM
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
9. Estimating and Evaluating Asset Pricing Models > 9.8 HJ Measure vs. the standard GMM
6. On the other hand, the optimal GMM provides the most efficient
estimate among estimates that use linear combinations of pricing errors
as moments, in the sense that the estimated parameters have the
smallest asy. covariance
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
References
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
References
• Andersen T.G., T Bollerslev, F.X. Diebold, and H. Ebens, 2001, ?The distribution
of Realized Stock Return Volatility, Journal of Financial Economics, 61, 43-76.
• Amir, Yaron, and Ravi Bansal, 2004. Risks for the long run: a potential
resolution of asset pricing puzzles. Journal of Finance 59, 1481-1509.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
References
• Ang, Andrew, Robert Hodrick, Yuhang Xing, and Xiaoyan Zhang, 2006. The
cross-section of volatility and expected returns. Jour- nal of Finance 23, 589-
609.
• Avramov, Doron, 2002. Stock return predictability and model un- certainty.
Journal of Financial Economics 64, 423-458.
• Avramov, Doron, 2004. Stock return predictability and asset pric- ing models.
The Review of Financial Studies 17, 699-738.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
References
• Avramov, Doron, and Tarun Chordia, 2006. Asset pricing models and financial
market anomalies. Review of Financial Studies 19, 1001-1040.
• Avramov, Doron, and Russ Wermers, 2006. Investing in mutual funds when
returns are predictable. forthcoming at Journal of Financial Economics.
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trades on daily volatility. Review of Financial Studies 19, 1241-1277.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
References
• Avramov, Doron, Robert Kosowski, Narayan Naik, and Melvyn Teo, 2007.
Investing in hedge funds when returns are predictable. Working Paper.
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evidence: discussion. Journal of Finance 32, 663 - 682.
• Barberis, Nicholas, 2000. Investing for the long run when returns are
predictable. Journal of Finance 55, 225-264.
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References
• Bawa, V.S., and R.W. Klein, 1976. The effect of estimation risk on optimal
portfolio choice. Journal of Financial Economics 3, 215–231.
• Bawa, V.S., S.J. Brown, and R.W. Klein, 1979, “Estimation Risk and Optimal
Portfolio Choice,” North-Holland, Amsterdam.
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References
• Berk, Jonathan, Richard Green, and Vikram Naik, 1999. Optimal investment,
growth options, adn security returns. Journal of Finance 54, 1553-1607.
• Bossaerts, Peter, and Pierre Hillion, 1999. Implementing statis- tical criteria to
select return forecasting models: what do we learn? Review of Financial
Studies 12, 405-428.
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel
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ASSET PRICING, Professor Doron Avramov, Finance Department, Hebrew University of Jerusalem, Israel