finance 450 general comments for final two weeks course goals, capm, apt, and haugen’s model,...

Finance 450 Finance 450 General CommentsGeneral Commentsfor Final Two Weeksfor Final Two Weeks

Course Goals,Course Goals,CAPM, APT, and Haugen’s Model,CAPM, APT, and Haugen’s Model,

Active vs. Passive Portfolio Active vs. Passive Portfolio Management,Management,

and Comments on Valuationand Comments on Valuation

Welcome Back from Welcome Back from Thanksgiving Break!Thanksgiving Break!

Good luck for the final two Good luck for the final two weeks of classes!weeks of classes!

General Overview and Course General Overview and Course GoalsGoals

• Give a man a fish, …Give a man a fish, …– and you feed him for a day;and you feed him for a day;

• Teach a man to fish, …Teach a man to fish, …– and you feed for for a lifetime;and you feed for for a lifetime;

• Teach a man to think, …Teach a man to think, …– and he won’t have to eat fish every day!and he won’t have to eat fish every day!

Goal of the CourseGoal of the Course

• Not to teach you everything there is to know Not to teach you everything there is to know about analyzing securities (that would be about analyzing securities (that would be impossible to do, given both the limited time impossible to do, given both the limited time available and the fact that the economic available and the fact that the economic environment is constantly changing and environment is constantly changing and evolving),evolving),

• But to teach you how to think about the markets, But to teach you how to think about the markets, so that you can be a more intelligent consumer of so that you can be a more intelligent consumer of any investment advice you receive and a more any investment advice you receive and a more critical reader of any future investment books you critical reader of any future investment books you read (which I would anticipate and recommend read (which I would anticipate and recommend that you do, since a lifetime of intelligent that you do, since a lifetime of intelligent investing requires a lifetime of learning, and the investing requires a lifetime of learning, and the more you read and learn, the better an investor more you read and learn, the better an investor you can be).you can be).

Goal of the CourseGoal of the Course

• Also, a goal is to help provide a better Also, a goal is to help provide a better foundation for those of you who are foundation for those of you who are considering going on for their CFA charters.considering going on for their CFA charters.

• As such, the intended emphasis of this As such, the intended emphasis of this course is on aspects of investment analysis course is on aspects of investment analysis that aren’t covered in other finance classes that aren’t covered in other finance classes and/or that are less readily accessible and/or that are less readily accessible through self-studythrough self-study

• Hopefully, the course has been successful Hopefully, the course has been successful in this regard, and you have learned a lot!in this regard, and you have learned a lot!

• Additional comment: virtual portfolio Additional comment: virtual portfolio project and English university systemproject and English university system

Now, back to the lecture!Now, back to the lecture!

CAPM, APT, and Haugen’s CAPM, APT, and Haugen’s ModelModel

• All three of these provide expected-return All three of these provide expected-return factor models that can be used to predict factor models that can be used to predict expected returns for individual securities expected returns for individual securities – Can be used in conjunction with Markowitz Can be used in conjunction with Markowitz

optimizationoptimization– Alternatively, these three models could be used to Alternatively, these three models could be used to

estimate the cost of equity capital for corporate estimate the cost of equity capital for corporate financial management decisionsfinancial management decisions

• But, each of the three models is But, each of the three models is fundamentally different from the other modelsfundamentally different from the other models

Asset Pricing TheoriesAsset Pricing Theories

Estimating expected return with the Estimating expected return with the Asset Pricing Models of Modern Asset Pricing Models of Modern Finance Finance

CAPM: strong assumption -- strong prediction.CAPM: strong assumption -- strong prediction.

Expected Return

Risk(Return

Variability)

Market Index on Efficient Set

MarketIndex

A

BC

Market Beta

Expected Return

Corresponding Security Market Line

xxx

xxxx

xxxx

xxxxxxx

xxx

xxx

MarketIndex

Expected Return

Risk(Return Variability)

Market Index Inside Efficient Set Corresponding Security Market Cloud

Expected Return

Market Beta

CAPM and Roll’s CritiqueCAPM and Roll’s Critique

• According to Richard Roll, the only testable According to Richard Roll, the only testable implication of CAPM is that the true market implication of CAPM is that the true market portfolio is (mean-variance) efficientportfolio is (mean-variance) efficient– i.e., CAPM implies M lies on the efficient frontieri.e., CAPM implies M lies on the efficient frontier– all the other implications of CAPM, such as the SML, are all the other implications of CAPM, such as the SML, are

a mathematical consequence of this and will follow a mathematical consequence of this and will follow naturally if the true market portfolio is efficient.naturally if the true market portfolio is efficient.

• But, the true market portfolio is But, the true market portfolio is unobservableunobservable (since it contains ALL risky assets)(since it contains ALL risky assets)– this leads to the problem of “benchmark error”, in which this leads to the problem of “benchmark error”, in which

the index used as a proxy for the market portfolio does the index used as a proxy for the market portfolio does not perfectly match the not perfectly match the truetrue market portfolio market portfolio

– nor can we ever observe the true efficient frontier (it nor can we ever observe the true efficient frontier (it must always be estimated, and different assumptions must always be estimated, and different assumptions will lead to different estimates)will lead to different estimates)

CAPM and Roll’s CritiqueCAPM and Roll’s Critique

• Thus, CAPM is ultimately untestable:Thus, CAPM is ultimately untestable:– If a linear relationship between beta and If a linear relationship between beta and

expected return is found, just shows that proxy expected return is found, just shows that proxy index is mean-variance efficient, not index is mean-variance efficient, not necessarily that the true market portfolio is necessarily that the true market portfolio is mean-variance efficient, mean-variance efficient,

– and vice versaand vice versa

• Other effects of Other effects of benchmark errorbenchmark error::– Beta would be wrongBeta would be wrong– The SML would be wrongThe SML would be wrong

Arbitrage Pricing Theory Arbitrage Pricing Theory (APT)(APT)

• CAPM is criticized by Roll because of CAPM is criticized by Roll because of the difficulties in selecting a proxy the difficulties in selecting a proxy for the market portfolio as a for the market portfolio as a benchmarkbenchmark

• An alternative pricing theory with An alternative pricing theory with fewer assumptions was developed by fewer assumptions was developed by Stephen Ross:Stephen Ross:

• Arbitrage Pricing TheoryArbitrage Pricing Theory

Arbitrage Pricing Theory - APTArbitrage Pricing Theory - APTThree major assumptions:Three major assumptions:

1. Capital markets are perfectly 1. Capital markets are perfectly competitivecompetitive

2. Investors always prefer more 2. Investors always prefer more wealth to less wealth with certaintywealth to less wealth with certainty

3. The stochastic process 3. The stochastic process generating asset returns can be generating asset returns can be expressed as a linear function of a expressed as a linear function of a set of set of KK factors or indexes factors or indexes

Assumptions of CAPMAssumptions of CAPMThat Were Not Required by That Were Not Required by APTAPTAPT does not assume APT does not assume

• A market portfolio that contains all A market portfolio that contains all risky assets, and is mean-variance risky assets, and is mean-variance efficientefficient

• Normally distributed security returns Normally distributed security returns • Quadratic utility functionQuadratic utility function


For For ii = 1 to N where: = 1 to N where: = return on asset = return on asset ii during a specified time period during a specified time period= expected return for asset = expected return for asset ii= = reaction in asset reaction in asset ii’s returns to movements in a ’s returns to movements in a

common factorcommon factor= a common factor with a zero mean that = a common factor with a zero mean that

influences the returns on all assetsinfluences the returns on all assets= a unique effect on asset = a unique effect on asset ii’s return that, by ’s return that, by

assumption, is completely diversifiable in large assumption, is completely diversifiable in large portfolios and has a mean of zeroportfolios and has a mean of zero

= number of assets= number of assets

ikikiiiitt bbbER ...21

Ri

Ei

bik

ki

N

Arbitrage Pricing Theory Arbitrage Pricing Theory (APT)(APT)BBik ik determine how each asset reacts to this determine how each asset reacts to this

common factorcommon factorEach asset may be affected by growth in Each asset may be affected by growth in

GNP, but the effects will differGNP, but the effects will differIn application of the theory, the factors are In application of the theory, the factors are

not identifiednot identified

Similarly to CAPM, the unique effects are Similarly to CAPM, the unique effects are independent and will be diversified away independent and will be diversified away in a large portfolioin a large portfolio


• APT assumes that, in equilibrium, the APT assumes that, in equilibrium, the return on a zero-investment, zero-return on a zero-investment, zero-systematic-risk portfolio is zero when systematic-risk portfolio is zero when the unique effects are diversified the unique effects are diversified awayaway

• The expected return on any asset The expected return on any asset i i (E(Eii)) can be expressed as: can be expressed as:


where:where:

= the expected return on an asset with = the expected return on an asset with zero systematic risk wherezero systematic risk where

ikkiii bbbE ...22110

0

0EEii

00 E1 = the risk premium related to each of the

common factors - for example the risk premium related to interest rate risk

bi = the pricing relationship between the risk premium and asset i - that is how responsive asset i is to this common factor K

Example of Two Stocks Example of Two Stocks and a Two-Factor Modeland a Two-Factor Model

= changes in the rate of inflation. The risk = changes in the rate of inflation. The risk premium related to this factor is 1 percent premium related to this factor is 1 percent for every 1 percent change in the ratefor every 1 percent change in the rate

1)01.( 1

= percent growth in real GNP. The average risk = percent growth in real GNP. The average risk premium related to this factor is 2 percent for premium related to this factor is 2 percent for every 1 percent change in the rateevery 1 percent change in the rate

= the rate of return on a zero-systematic-risk = the rate of return on a zero-systematic-risk asset (zero beta: asset (zero beta: bbojoj=0) is 3 percent=0) is 3 percent

2)02.( 2

)03.( 3 3


= the response of asset = the response of asset XX to changes in the to changes in the rate of inflation is 0.50rate of inflation is 0.50

1xb )50.( 1 xb

= the response of asset = the response of asset YY to changes in the to changes in the rate of inflation is 2.00rate of inflation is 2.00 )50.( 1 yb

1yb

= the response of asset = the response of asset XX to changes in the to changes in the growth rate of real GNP is 1.50growth rate of real GNP is 1.50

= the response of asset = the response of asset YY to changes in the to changes in the growth rate of real GNP is 1.75growth rate of real GNP is 1.75

2xb

2yb)50.1( 2 xb

)75.1( 2 yb


= .03 + (.01)= .03 + (.01)bbi1i1 + (.02) + (.02)bbi2i2

EExx = .03 + (.01)(0.50) + (.02)(1.50) = .03 + (.01)(0.50) + (.02)(1.50)

= .065 = 6.5%= .065 = 6.5%

EEyy = .03 + (.01)(2.00) + (.02)(1.75) = .03 + (.01)(2.00) + (.02)(1.75)

= .085 = 8.5%= .085 = 8.5%

22110 iii bbE

Arbitrage Pricing Theory Arbitrage Pricing Theory (APT)(APT)Multiple factors expected to have an Multiple factors expected to have an

impact on all assets:impact on all assets:– InflationInflation– Growth in GNPGrowth in GNP– Major political upheavalsMajor political upheavals– Changes in interest ratesChanges in interest rates– And many more….And many more….

Contrast with CAPM insistence that only Contrast with CAPM insistence that only beta is relevantbeta is relevant

APT vs. CAPMAPT vs. CAPM

• In form, APT is similar to CAPM, but In form, APT is similar to CAPM, but with multiple risk factors, rather than with multiple risk factors, rather than just one market risk factor, driving just one market risk factor, driving expected returnsexpected returns

• In practice, APT appears to work better In practice, APT appears to work better than CAPMthan CAPM

• But, while CAPM has Roll’s Critique, But, while CAPM has Roll’s Critique, APT has Shanken’s Critique …APT has Shanken’s Critique …

Shanken’s Challenge to Shanken’s Challenge to Testability of the APTTestability of the APT

• If returns are not explained by a model, it is not If returns are not explained by a model, it is not considered rejection of a model; however if the considered rejection of a model; however if the factors do explain returns, it is considered supportfactors do explain returns, it is considered support

• APT has no advantage because the factors need APT has no advantage because the factors need not be observable, so equivalent sets may conform not be observable, so equivalent sets may conform to different factor structuresto different factor structures

• Empirical formulation of the APT may yield different Empirical formulation of the APT may yield different implications regarding the expected returns for a implications regarding the expected returns for a given set of securitiesgiven set of securities

• Thus, the theory cannot explain differential returns Thus, the theory cannot explain differential returns between securities because it cannot identify the between securities because it cannot identify the relevant factor structure that explains the relevant factor structure that explains the differential returnsdifferential returns

The Arbitrage Pricing TheoryThe Arbitrage Pricing Theory

Estimating the macro-economic betas.Estimating the macro-economic betas.Obtain a characteristic line for each risk Obtain a characteristic line for each risk

factorfactorRegress return on stock against risk factorRegress return on stock against risk factor

Relationship Between Return to General Relationship Between Return to General Electric and Changes in Interest Rates Electric and Changes in Interest Rates

-25%-25%

-20%-20%

-15%-15%

-10%-10%

-5%-5%

0%0%

5%5%

10%10%

15%15%

20%20%

25%25%

Return to G.E.Return to G.E.

-10%-10% -5%-5% 0%0% 5%5% 10%10%

Percentage Change in Yield on Long-term Govt. Bond Percentage Change in Yield on Long-term Govt. Bond

Line of Best FitLine of Best Fit

April, 1987April, 1987

The Arbitrage Pricing TheoryThe Arbitrage Pricing Theory

Estimating the macro-economic betas.Estimating the macro-economic betas. No-arbitrage condition for asset pricing.No-arbitrage condition for asset pricing.

If risk-return relationship is non-linear, you can If risk-return relationship is non-linear, you can arbitrage.arbitrage.

Asset Pricing TheoriesAsset Pricing Theories

Estimating expected return with the Asset Estimating expected return with the Asset Pricing Models of Modern Finance Pricing Models of Modern Finance

CAPM: strong assumption -- strong prediction.CAPM: strong assumption -- strong prediction. APT: weak assumption -- weak prediction.APT: weak assumption -- weak prediction.

Curved Relationship Between Expected Return and Interest Rate BetaCurved Relationship Between Expected Return and Interest Rate Beta

-15%-15%

-5%-5%

5%5%

15%15%

25%25%

35%35%

Expected ReturnExpected Return

-3-3 -1-1 11 33Interest Rate BetaInterest Rate Beta

AABB

CC

DD EE FF

The Arbitrage Pricing TheoryThe Arbitrage Pricing Theory Two stocks:Two stocks:

A: E(r) = 4%; Interest-rate beta = -2.20A: E(r) = 4%; Interest-rate beta = -2.20 B: E(r) = 26%; Interest-rate beta = 1.83B: E(r) = 26%; Interest-rate beta = 1.83 Invest 54.54% in E and 45.46% in A.Invest 54.54% in E and 45.46% in A. Portfolio E(r) = .5454 * 26% + .4546 * 4% = 16%Portfolio E(r) = .5454 * 26% + .4546 * 4% = 16% Portfolio beta = .5454 * 1.83 + .4546 * -2.20 = 0Portfolio beta = .5454 * 1.83 + .4546 * -2.20 = 0 With many combinations like this, you can create a risk-free portfolio with a 16% With many combinations like this, you can create a risk-free portfolio with a 16%

expected return.expected return.

The Arbitrage Pricing TheoryThe Arbitrage Pricing Theory Two different stocks:Two different stocks:

C: E(r) = 15%; Interest-rate beta = -1.00C: E(r) = 15%; Interest-rate beta = -1.00 D: E(r) = 25%; Interest-rate beta = 1.00D: E(r) = 25%; Interest-rate beta = 1.00 Invest 50.00% in E and 50.00% in A.Invest 50.00% in E and 50.00% in A. Portfolio E(r) = .5000 * 25% + .4546 * 15% = 20%Portfolio E(r) = .5000 * 25% + .4546 * 15% = 20% Portfolio beta = .5000 * 1.00 + .5000 * -1.00 = 0Portfolio beta = .5000 * 1.00 + .5000 * -1.00 = 0 With many combinations like this, you can create a risk-free portfolio with With many combinations like this, you can create a risk-free portfolio with

a 20% expected return. Then sell-short the 16% and invest the proceeds a 20% expected return. Then sell-short the 16% and invest the proceeds in the 20% to arbitrage.in the 20% to arbitrage.

The Arbitrage Pricing TheoryThe Arbitrage Pricing Theory No-arbitrage condition for asset pricing.No-arbitrage condition for asset pricing.

If risk-return relationship is non-linear, you can If risk-return relationship is non-linear, you can arbitrage.arbitrage.

Attempts to arbitrage will force linearity in relationship Attempts to arbitrage will force linearity in relationship between risk and return.between risk and return.

APT Relationship Between Expected Return and Interest Rate Beta APT Relationship Between Expected Return and Interest Rate Beta

-15%

-5%

5%

15%

25%

35%

Expected ReturnExpected Return

-3 -1 1 3Interest Rate Beta

A B

C

D

EF

The Arbitrage Pricing TheoryThe Arbitrage Pricing Theory But, finite samples and fat-tailed distributions preclude the formation of the But, finite samples and fat-tailed distributions preclude the formation of the

riskless hedges that are necessary to ensure that the theory holdsriskless hedges that are necessary to ensure that the theory holds E.g., LTCME.g., LTCM

More significantMore significantly, true risk factors never known for surely, true risk factors never known for sure Moreover, if markets are inefficient, then factors other than risk factors may also Moreover, if markets are inefficient, then factors other than risk factors may also

be importantbe important This is the key contribution of HaugenThis is the key contribution of Haugen

Haugen’s ApproachHaugen’s Approach

• Two components:Two components:– Risk factor modelRisk factor model

•for modeling stocks’ risks and covariancesfor modeling stocks’ risks and covariances

– Ad hocAd hoc expected return factor model expected return factor model •for predicting stocks’ expected returnsfor predicting stocks’ expected returns

•allow both risk factors and non-risk factorsallow both risk factors and non-risk factors

• Combine together using Markowitz Combine together using Markowitz portfolio optimizationportfolio optimization

Probability Distribution For Returns to a PortfolioProbability Distribution For Returns to a Portfolio

Possible Rates of Returns

Probability

Expected Return

Variance of Return

Risk Factor ModelsRisk Factor Models

• The variance of stock returns can be split The variance of stock returns can be split into two components:into two components: Variance = systematic risk + diversifiable riskVariance = systematic risk + diversifiable risk

Systematic risk is modeled using an APT-type Systematic risk is modeled using an APT-type risk-factor modelrisk-factor model

Measures extent to which stocks’ returns [jointly] move Measures extent to which stocks’ returns [jointly] move up and down over timeup and down over time

Estimated using time-series dataEstimated using time-series data

Diversifiable risk is reduced through optimal Diversifiable risk is reduced through optimal diversificationdiversification

Expected Return Factor ModelsExpected Return Factor Models

• Expected return factor models Expected return factor models measure / predict the extent to which measure / predict the extent to which the stocks’ returns are different from the stocks’ returns are different from each other within a given period of time.each other within a given period of time.

Expected Return Factor ModelsExpected Return Factor Models

• The factors in an expected return model represent The factors in an expected return model represent the character of the companies.the character of the companies.

• They might include the history of their stock They might include the history of their stock prices, its size, financial condition, cheapness or prices, its size, financial condition, cheapness or dearness of prices in the market, etc.dearness of prices in the market, etc.– Unlike CAPM and APT, not only risk factors such as Unlike CAPM and APT, not only risk factors such as

market beta or APT betas are includedmarket beta or APT betas are included

• Factor payoffs are estimated by relating individual Factor payoffs are estimated by relating individual stock returns to individual stock characteristics stock returns to individual stock characteristics over the over the cross-sectioncross-section of a stock population of a stock population ((here the largest 3000 U.S. stockshere the largest 3000 U.S. stocks).).

Five Factor FamiliesFive Factor Families

• Risk Risk – Market and APT betas, TIE, debt ratio, etc., Market and APT betas, TIE, debt ratio, etc.,

values and trends thereof values and trends thereof

• LiquidityLiquidity– Market cap., price, trading volume, etc.Market cap., price, trading volume, etc.

• Price level Price level – E/P, B/P, Sales/P, CF/P, Div/PE/P, B/P, Sales/P, CF/P, Div/P

• ProfitabilityProfitability– Profit margin, ROE, ROA, earnings surprise, etc.Profit margin, ROE, ROA, earnings surprise, etc.

• Price history (technical factors)Price history (technical factors)– Excess return over past 1, 2, 3, 6, 12, 24, & 60 Excess return over past 1, 2, 3, 6, 12, 24, & 60

monthsmonths

The Most Important The Most Important FactorsFactors

• The monthly slopes (payoffs) are averages The monthly slopes (payoffs) are averages over the period 1979 through mid 1986.over the period 1979 through mid 1986.

• ““T” statistics on the averages are T” statistics on the averages are computed, and the stocks are ranked by computed, and the stocks are ranked by the absolute values of the “Ts”.the absolute values of the “Ts”.

Most Important FactorsMost Important Factors

1979/01 through1979/01 through1986/061986/06

1986/07 through 1993/121986/07 through 1993/12

FactorFactor MeanMean ConfidenceConfidence MeanMean ConfidenceConfidence

One-month excess returnOne-month excess return -0.97%-0.97% 99%99% -0.72%-0.72% 99%99%

returnreturnTwelve-month excessTwelve-month excess 0.52%0.52% 99%99% 0.52%0.52% 99%99%

Trading volume/marketTrading volume/marketcapcap

-0.35%-0.35% 99%99% -0.20%-0.20% 98%98%

Two-month excess returnTwo-month excess return -0.20%-0.20% 99%99% -0.11%-0.11% 99%99%

Earnings to priceEarnings to price 0.27%0.27% 99%99% 0.26%0.26% 99%99%

Return on equityReturn on equity 0.24%0.24% 99%99% 0.13%0.13% 97%97%

Book to priceBook to price 0.35%0.35% 99%99% 0.39%0.39% 99%99%

Trading volume trendTrading volume trend -0.10%-0.10% 99%99% -0.09%-0.09% 99%99%

Six-month excess returnSix-month excess return 0.24%0.24% 99%99% 0.19%0.19% 99%99%

Cash flow to priceCash flow to price 0.13%0.13% 99%99% 0.26%0.26% 99%99%

The Most Important The Most Important FactorsFactors• Among the factors that are significant (i.e., that can Among the factors that are significant (i.e., that can

be used to distinguish between which companies will be used to distinguish between which companies will have higher returns and which will have lower have higher returns and which will have lower returns) are:returns) are:

– A number of liquidity factorsA number of liquidity factors

– Various fundamental factors, indicating value with growthVarious fundamental factors, indicating value with growth

– Technical factors, indicating short-term reversals and Technical factors, indicating short-term reversals and intermediate term momentumintermediate term momentum

• Suggest that technical factors provide marginal value when Suggest that technical factors provide marginal value when used in conjunction with fundamental analysisused in conjunction with fundamental analysis

– Notably, no CAPM or APT risk factors are included!Notably, no CAPM or APT risk factors are included!

The Great RaceThe Great Race(From Ch. 13)(From Ch. 13)

A Test of RelativeA Test of Relative Predictive Power Predictive Power

1980 -19971980 -1997

Model employing factors Model employing factors exploiting the market’s tendencies exploiting the market’s tendencies

to over- and under-reactto over- and under-react

vs.vs.

Models employing risk factors only Models employing risk factors only (“deductive” models of modern (“deductive” models of modern

finance).finance).

The The Ad HocAd Hoc Expected Expected Return Factor ModelReturn Factor Model

• RiskRisk

• LiquidityLiquidity

• ProfitabilityProfitability

• Price levelPrice level

• Price historyPrice history

• Earnings revision and surpriseEarnings revision and surprise

Decile Returns for the Ad Hoc Factor Model Decile Returns for the Ad Hoc Factor Model (1980 through mid 1997)(1980 through mid 1997)

2 3 4 5 6 7 8 9 10Decile0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1

AverageAverage Annualized Annualized

ReturnReturn

The Capital Asset The Capital Asset Pricing ModelPricing Model

• Market beta measured over the trailing Market beta measured over the trailing 3 to 5-year periods). 3 to 5-year periods).

• Stocks ranked by beta and formed into Stocks ranked by beta and formed into deciles monthly.deciles monthly.

Decile Returns for CAPM ModelDecile Returns for CAPM Model

33 44 55 66 77 88 99 1010 DecileDecile0%0%

5%5%

10%10%

15%15%

20%20%

25%25%

30%30%

35%35%

40%40%

45%45%

11 22

Average Average Annualized Annualized

ReturnReturn

The Arbitrage Pricing The Arbitrage Pricing TheoryTheory

• Macroeconomic FactorsMacroeconomic Factors– Monthly T-bill returnsMonthly T-bill returns

– Long-term T-bond returns less short-termLong-term T-bond returns less short-term

– T-bond returns less low-gradeT-bond returns less low-grade

– Monthly inflationMonthly inflation

– Monthly change in industrial productionMonthly change in industrial production

• Beta EstimationBeta Estimation– Betas re-estimated monthly by regressing stock returns Betas re-estimated monthly by regressing stock returns

on economic factors over trailing 3-5 yearson economic factors over trailing 3-5 years

• Payoff ProjectionPayoff Projection– Next month’s payoff is average of trailing 12 monthsNext month’s payoff is average of trailing 12 months

Average Returns for APT ModelAverage Returns for APT Model

Annualized Annualized

22 33 44 55 66 77 88 99 1010 DecileDecile0%0%

5%5%

10%10%

15%15%

20%20%

25%25%

30%30%

35%35%

40%40%

45%45%

11

Average Average

ReturnReturn

Overall ResultsOverall Results

• Ad Hoc Expected Return Factor ModelAd Hoc Expected Return Factor Model– Average Annualized Spread Between Deciles 1 & 10Average Annualized Spread Between Deciles 1 & 10 46.04%46.04%– Years with Negative SpreadsYears with Negative Spreads 0 years0 years

• Models Based on MODERN FINANCEModels Based on MODERN FINANCE– CAPMCAPM

• Average Annualized Spread Between Deciles 1 & 10Average Annualized Spread Between Deciles 1 & 10 -6.94%-6.94%

• Years with Negative SpreadsYears with Negative Spreads 13 years13 years– APTAPT

• Average Annualized Spread Between Deciles 1 & 10Average Annualized Spread Between Deciles 1 & 10 6.06%6.06%

• Years with Negative SpreadsYears with Negative Spreads 6 years6 years

CAPM vs. APT vs. HaugenCAPM vs. APT vs. Haugen

• CAPM – one risk factor included in modelCAPM – one risk factor included in model• APT – multiple risk factors included in modelAPT – multiple risk factors included in model

– More realistic and appears to work better than CAPM in More realistic and appears to work better than CAPM in applicationsapplications

• Haugen’s model – multiple risk factors as well as Haugen’s model – multiple risk factors as well as non-risk factors potentially includednon-risk factors potentially included– Actual model applied will vary over time as market Actual model applied will vary over time as market

conditions changeconditions change– More adaptable in face of potential market inefficienciesMore adaptable in face of potential market inefficiencies– Appears to work much better than either CAPM or APT in Appears to work much better than either CAPM or APT in

practice!practice!

Getting to Heaven Getting to Heaven and Hell in the and Hell in the Stock MarketStock Market(From Ch. 14)(From Ch. 14)

The Position of Portfolios in Abnormal Profit SpaceThe Position of Portfolios in Abnormal Profit Space

Effici

ent M

arke

t

Effici

ent M

arke

t

Line

Line

TrueTrue Abnormal Profit Abnormal Profit

Super StocksSuper Stocks

Stupid StocksStupid Stocks

PricedPriced Abnormal ProfitAbnormal Profit


Effici

ent M

arke

t

Effici

ent M

arke

t

Line

Line


Investment Investment HeavenHeaven

Stupid StocksStupid Stocks

PricedPriced Abnormal Profit Abnormal Profit


Effici

ent M

arke

t

Effici

ent M

arke

t

Line

Line



InvestmentInvestmentHellHell

PricedPriced Abnormal Profit Abnormal Profit


Effici

ent M

arke

t

Effici

ent M

arke

t

Line

Line



InvestmentInvestmentHellHell

PricedPriced Abnormal ProfitAbnormal Profit

Can’t get to heaven by going around

the corner

You must go directly to heaven

How do you get to How do you get to Investment Heaven?Investment Heaven?

Three main steps Three main steps in Haugen’s approachin Haugen’s approach::– Use risk factor models to estimate variances and Use risk factor models to estimate variances and

covariancescovariances– Use ad hoc expected return factor models to Use ad hoc expected return factor models to

determine desired stock characteristics and determine desired stock characteristics and estimate expected returnsestimate expected returns• Cannot just screen sequentially (“going around the Cannot just screen sequentially (“going around the

corner”) for stocks with the desired characteristicscorner”) for stocks with the desired characteristics

– Combine this information into optimal portfolios Combine this information into optimal portfolios through Markowitz optimizationthrough Markowitz optimization

finance 450 general comments for final two weeks course goals, capm, apt, and haugen’s model,...

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valuation slide

lifetime of learning

aspects of investment

future investment books

intelligent consumer

expected returns