Download - Alternative View of Risk and Return
![Page 1: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/1.jpg)
Alternative View of Risk and Return
![Page 2: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/2.jpg)
Multi Factor Pricing Models
Like CAPM, an asset’s return is related to common risks
But we now allow for their to be more than a single source of riskOil
2
![Page 3: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/3.jpg)
Example: Fama French Model
)()()( MKTβHMLβSMLβrR MHMLf SML
Returns are a function of three risk factorsSize factor
Return on the averages small firm minus the average large firm
Value factor Return on the average value firm minus the average growth
firm
Market Factor Same as CAPM
3
![Page 4: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/4.jpg)
4
Multi-Factor Betas Since we are allowing for multiple risk factors, how will
change? i refers to the individual stock j refers to the source of risk
βi,j = i,j / j2
![Page 5: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/5.jpg)
Example What is a stock’s expected return if its betas
are:SML: 0.5HML: 3.0Mkt: 2.0SML is 8%, HML is 5%, the market risk premium
is 4%, and the risk free rate is 3%
5
![Page 6: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/6.jpg)
Why We Care
Another investment rule which is commonly used
Provides another viewpoint regarding how returns are generated
6
![Page 7: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/7.jpg)
Market Efficiency
![Page 8: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/8.jpg)
News and Returns All news, and announcements contain anticipated and
unexpected components The market prices assets based on what is
expected to happen (Anticipated news)Changes in expectations will cause the price to move
Unexpected news is a surprise and will cause prices to moveSurprises cause unexpected returns
8
![Page 9: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/9.jpg)
9
Breaking Returns Down
A security’s return is comprised of:1. The expected return, based on expectations2. The un-expected return, based on surprises
Therefore, a stock’s return is:
return theofpart unexpected theis
return theofpart expected theis
where
U
R
URR
![Page 10: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/10.jpg)
Where does U come from? Systematic Surprises:
Unique Surprises:
10
![Page 11: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/11.jpg)
11
Breaking Returns Down (2)
We defined returns as: We can break U down further: is the return earned because of unexpected
movements in systematic risk is the return from unique surprises
URR
mRR
m
![Page 12: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/12.jpg)
12
Example Lets use the Fama French factors:
SML, HML, and Mkt Our model is:
εFβFβFβRR MktMktHMLHMLSMLSML
![Page 13: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/13.jpg)
Surprises Expected SML to be 3%, but it was 8%; surprise is?
Expected HML to be 4%, but it was 1%; surprise is?
Expected Mkt to be 10%, but it was stable; surprise is?
Finally, the firm attracted a “superstar” CEO, and this unanticipated development contributes 1% to the return.
13
![Page 14: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/14.jpg)
14
Example Betas The stock’s betas are:
1. SML = -2.30
2. HML = 1.50
3. Mkt = 0.50
The stock’s expected return is 8%
![Page 15: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/15.jpg)
15
Example’s Actual Return
εFβFβFβRR MktMktHMLHMLSMLSML
![Page 16: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/16.jpg)
Underlying Assumption
The assumption we made, and that drove the last example, is that the stock is priced in an efficient market
16
![Page 17: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/17.jpg)
What is an efficient market? A market is efficient when it uses all available
information to price assets.Information is quickly incorporated into prices
Efficiency is the degree to which prices reflect available information.
Stock prices only respond to surprises, which arrives randomly, so prices follow a random walk
Price tomorrow = today’s price + random (+/-)
17
![Page 18: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/18.jpg)
18
Price: Today and Tomorrow
Do you see a pattern that you want to put money on?
![Page 19: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/19.jpg)
19
Reactions to Beating Expectations
Efficient Response
Over Reaction
Under Reaction
![Page 20: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/20.jpg)
20
Reaction to Not Meeting Expectations
Over Reaction
Efficient Reaction
Under Reaction
![Page 21: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/21.jpg)
21
Potential Causes of Efficient Markets
Investor RationalityEveryone is rational → Everyone makes the right
decision Independent Deviation from Rationality
No one is rational → Everyone makes the wrong decision but each makes a different wrong decision
Average out the wrongness
ArbitrageOnly some people are rational → Smart money takes
from less smart money
![Page 22: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/22.jpg)
22
Types of Efficient Markets
Weak
Semi-Strong
Strong
![Page 23: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/23.jpg)
23
Weak Form Efficiency
Prices reflect all information contained in past prices and volumesNo investor is able to form a trading strategy based
on historic prices and volumes and earn an excess return
![Page 24: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/24.jpg)
24
Disbelievers
Chartists, or Technical AnalystsAnalyze “charts” of a stock‘s Price and/or Volume
Chartist believe in identifiable and predictable patterns in these characteristicsMake investment decisions based on these patterns
Brokerage firms tend to love chartists
![Page 25: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/25.jpg)
25
Head and Shoulders
![Page 26: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/26.jpg)
Why Technical Analysis Fails
-If there is a profitable pattern, everyone would do it
-If everyone follows the same strategy competition will eliminate any opportunity associated with the pattern
Sto
ck P
rice
Time
Sell
Sell
Buy
Buy
![Page 27: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/27.jpg)
27
Semi-Strong Form Efficiency
Security prices reflect all publicly available information.Encompasses weak form efficiency
Publicly available information includes: Historical price and volume information
Published accounting statements
Information found in the WSJ
![Page 28: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/28.jpg)
28
Disbelievers
Fundamental AnalystsUse revenues, earnings, future growth forecasts,
return on equity, profit margins, and other data to determine a company's underlying value and potential for future growth (Financial Statements)
These guys make more sense than technical analysts. Why?
![Page 29: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/29.jpg)
29
Strong Form Efficiency Strong form efficiency says that anything
pertinent to the stock price and known to at least one investor is already incorporated in the security’s price.Public & PrivateImplies: Insider trading will not earn excess return
Strong form efficiency incorporates weak and semi-strong form efficiency.
![Page 30: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/30.jpg)
Disbelievers
Pretty much everyone Insiders trading is generally profitable
Galleon Raj Rajaratnam
Martha Stewart
30
![Page 31: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/31.jpg)
31
What EMH Does and Does NOT Say
Investors can throw darts to select stocks. Kind of: We still need to consider risk
Prices are random or uncaused. Prices reflect information. Price CHANGES are driven by new information,
which by definition is random
![Page 32: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/32.jpg)
32
Implications of Efficient Markets Purchase or sale of any security can never be a
positive NPV transaction. Trust market prices Stocks with similar risk are substitutes Mutual fund managers cannot systematically
outperform the market
![Page 33: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/33.jpg)
33
The Evidence The record on the EMH is extensive,
and generally supportive of the market being semi-strong form efficient
![Page 34: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/34.jpg)
34
Event Studies
Event Studies examine returns around information release datesEX: Earnings, Dividend announcementsA test of semi-strong form efficiency
Look at how quickly prices adjust to the informationLooking for under-reaction, over-reaction, early
reaction, or delayed reaction around the event.
![Page 35: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/35.jpg)
35
Event Study Results The studies generally support the view that the
market is semi-strong form efficient. Studies suggest that markets may even have
some foresight into the future, i.e., news tends to leak out in advance of public announcements.
![Page 36: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/36.jpg)
36
Event Studies: Dividend OmissionsCumulative Abnormal Returns for Companies Announcing
Dividend Omissions
0.146 0.108
-0.72
0.032-0.244-0.483
-3.619
-5.015-5.411-5.183
-4.898-4.563-4.747-4.685-4.49
-6
-5
-4
-3
-2
-1
0
1
-8 -6 -4 -2 0 2 4 6 8
Days relative to announcement of dividend omission
Cum
ulat
ive
abno
rmal
ret
urns
(%
)
Efficient market response to “bad news”
![Page 37: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/37.jpg)
37
The Record of Mutual Funds If the market is semi-strong form efficient,
then mutual fund managers, should not be able to consistently beat the average market return
When we compare the record of mutual fund performance to a market index, we see that mutual funds are not able to CONSISTENTLY beat the market.Consistent with the market being semi-strong form
efficient
![Page 38: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/38.jpg)
38
Mutual Fund Performance
Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and Seemingly Unrelated Assets,” Journal of Financial Exonomics, 63 (2002).
-2.13%
-8.45%
-5.41%
-2.17% -2.29%
-1.06%-0.51%-0.39%
All funds Small-companygrowth
Other-aggressive
growth
Growth Income Growth andincome
Maximumcapital gains
Sector
![Page 39: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/39.jpg)
39
Insider trading
Strong form market efficiency implies that even insiders trading on private information cannot earn excess return
A number of studies find that insiders are able to earn abnormal profitsViolation of Strong form efficiency
![Page 40: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/40.jpg)
40
Verdict on Market Efficiency
Market is pretty efficient Opportunities for easy profits are rare. Financial managers should assume, at least as
a starting point, that security prices are fair and that it is difficult to outguess the market.
New information is rapidly incorporated into the prices.
![Page 41: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/41.jpg)
41
EMH Exercises Indicate whether or not the EMH is contradicted, if
so which form of EMH is contradicted An investor consistently earn an abnormal return over
that expected by the market by examining charts of historical prices
The acquisition of the latest annual report of a company enables an investor to earn an abnormal return.
A stock which has been fluctuating between $25 and $27 in the last three months suddenly rises to $40 per share right after management announces a new project that has a promising impact on the firm's expected future cash inflows.
By subscribing to the Value Line Investment Survey, an investor can earn at least 5% over that earned by the market on comparable risk investments.
![Page 42: Alternative View of Risk and Return](https://reader035.vdocuments.us/reader035/viewer/2022062517/56812e51550346895d93f12c/html5/thumbnails/42.jpg)
Why We Care
Offering several points of view on how the market works, and the evidence for and againstUsing this you can form your own opinion about
how the market works and invest accordingly
42