The Capital Asset Pricing Model Theory, Econometrics, and Evidenc

In this thesis three aspects of the CAPM model are investigated. The first aspect is the theoreticalbackground of the model. Here, mean-variance analysis (MVA) is thoroughly examined. We first present mathematical arguments from utility theory that can motivate the implementation of MVA. Then, we examine efficient portfolios in a mean-standard deviation space assuming there is no risk-free asset. We show the incentive to diversify ones portfolio and derive the efficient frontierconsisting of the portfolios with the maximum expected return for a given variance. Using mathematical and economic arguments, we find out that the market portfolio consisting of all risky assets is mean-variance efficient. We then include a riskless asset in the analysis and get the Capital Asset Market Line (CML) in a mean-standard deviation space. We argue that this is the efficient frontier when a risk-free rate exists. We also present the separation theorem which implies that all investors will maximize utility in some combination between the risk-free asset and the market portfolio. Based on the CML, we derive the Capital Asset Pricing Model (CAPM) in three differentways. The first two represent the original approaches from the architects behind the model. The last approach extends the formal derivation of the efficient frontier when only risky assets exist to include the risk-free rate. We find that the CAPM relates the expected return on any asset to its beta.

We argue that when investors only care about expected return and variance, beta makes sense as arisk measure. As beta is based on the covariance of returns between an asset and the market portfolio, it follows that CAPM only rewards investors for their portfolios responsiveness to swings in the overall economic activity. We find that this makes sense, as rational investors can diversify away all but the systematic risk of their portfolios. In the second part of the thesis, the econometric methods for testing the CAPM are developed. First, the traditional model is rewritten in order to work with excess returns. We then focus on testing the mean-variance efficiency of the market portfolio. We impose the assumption that returns are independent and identically distributed and jointly multivariate normal. Based on this assumption, we derive the joint probability density function (pdf) of excess returns conditional on the market risk premium. Using this pdf we first derive maximum likelihood estimators of the market model parameters. We then show that they are, in fact, equivalent to the ordinary least squares estimators.

A number of different test statistics are derived based on these estimators. The first is an asymptoticWald type test. We then transform this test into an exact F-test. Moreover, we develop anasymptotic likelihood ratio test including a corrected version with better finite-sample properties.

Also, noting that the above distributional assumptions are rather strict, we use the Generalized Method of Moments (GMM) framework to develop a test robust to heteroskedasticity, temporal dependence and non-normality. 

Finally, we present some cross-sectional tests of other implications of the CAPM. Specifically, we develop statistics to check whether the empirical market risk premium is significant and positive and whether other risk measures than beta have explanatory power regarding expected excess returns. The third part of the thesis is an empirical study. It starts out by discussing a number of relevant topics regarding the implementation of the statistical tests. In specific, we discuss the choice of proxies, the sample period length and frequency, and the construction of the dependant variable.

Then, the tests are carried out on a 30 year sample of American stocks. For the overall period, we cannot reject the mean-variance efficiency of the proxy for the market portfolio. However, for the sub-periods of 5 years, the results are not so clear-cut. We also find that the empirical risk premium is not significant. The last point clearly contradicts the CAPM framework.

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Asset Pricing in the Stock and Options Markets

This thesis comprises three essays on asset pricing on the stock and options markets. The first essay finds a positive relation between the slope of the volatility term structure and subsequent option returns. The second essay finds a negative relation between realized skewness, extracted from high-frequency data, and stock returns. The third essay finds a negative relation between price jumps of intraday data and future stock returns.

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Heterogeneous Consumption and Asset Pricing in Global Financial Markets

Sergei Sarkissian

This dissertation studies the impact of heterogeneous consumption growth rates across countries on cross-country differences in expected asset returns and tests on the country level the implications of the Constantinides and Duffie (1996) CCAPM which accounts for the investors’ heterogeneity and existence of incomplete markets. The inclusion of the cross-country dispersion of countries’ per-capita consumption growth rates into the standard power utility model has a positive impact on the ability of the model to resolve the risk-free rate, equity premium, and forward premium puzzles. The estimates of the risk aversion parameter are lower, the standard errors are generally smaller, and the time preference parameter decreases towards unity. In addition, the consumption model with  heterogeneity leads to a decrease in the estimates of the Hansen and Jagannathan (1997) distance measure for all types of assets and of most average pricing errors. The tests of the beta pricing relation derived from the original model reveal that more realistic parameter estimates and better overall fit of the new model are achieved primarily due to the negative relation between expected asset returns and the covariance of asset returns with the cross-country consumption dispersion.

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Essays in Macroeconomics and Asset Pricing

In this dissertation Manaenkov study the role recursive preferences due to Epstein and Zin (1989) play in macroeconomics and asset pricing. First, he combine recursive preferences with long-run productivity growth risk and study the implications for asset pricing. Second, he focus on the preference for the timing of resolution of uncertainty that arises when one uses Epstein-Zin recursive utility, and the interaction of such preference with incentives to invest into technology that could cause uncertainty to be realized early. In the first part of this dissertation he setup a monetary production economy with capital accumulation and recursive preferences and evaluate model’s implications for pricing of equity and nominal default-free bonds. Plausibly parameterized model generates equity premium of about 1%, large and positive nominal bond term premium. Equity and nominal bond excess returns are forecastable, but considerably less so than in the data. Model generates large inflation premium, that is fairly sensitive to the parameters of interest rate rule. In the second part I investigate the interaction between government policy and incentives to invest in risk-control technology in a heterogenous preference setting. Empirical studies show that intertemporal elasticity of substitution varies a great deal within population. He setup a stylized model where such heterogeneity leads to difference in preference for the timing of the resolution of uncertainty. The uncertainty in the model is about the future productivity of a risky technology. Investors can choose to observe an early signal about their individual future productivity (hence shifting the resolution of uncertainty to the earlier date) and cut exposure in case of a bad signal via conversion of a part of risky technology investment into safe investment. Government in the model has the power to influence the cost of borrowing and the return of the safe investment. Is how that government policy has important implications both for the individual choice of whether to observe a signal about future productivity and for the aggregate output.

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Essays in Monetary Policy and Asset Pricing

The estimated yield-curve model explains the “snake-shaped” term structure of volatility in yields, based on interest-rate smoothing and policy inertia. Macroeconomic surprises are only temporary components of macro variables. This means that the impact of these surprises on longer yields needs to occur over time through a “policy-inertia factor.” The model improves the fit of bond prices over a 3-latent-factor model, especially for short maturities. A policy rule is identified from weekly yield data and is found to provide a good description of the target. In fact, model-based forecasts of future target rates outperform several benchmarks.

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Essays in Asset Pricing

All asset pricing models, whether of securities, cars or watches, are versions of the basic demand and supply model where prices are determined by the intersection of demand and supply. The demand and supply functions reflect the preferences of consumers and producers. The demand and supply structure is evident in the CAPM. In that model investors on both the demand and supply sides prefer mean-variance-efficient portfolios and the aggregation of their preferences yields an asset pricing model where expected returns of securities vary by beta. The demand and supply structure is not nearly as evident in the Fama and French 3-factor asset pricing model. Market capitalization and book-to-market ratios were associated with anomalies relative to the CAPM long before their debut in the 3-factor model, but the argument that market capitalization and book-to-market ratios proxy for risk is not fully supported by the evidence. The purpose of this paper is to help link asset pricing models to the preferences of investors. We outline a behavioral asset pricing model where expected returns are high when objective risk is high and also when subjective risk is high. High subjective risk comes with negative affect and low subjective risk comes with positive affect. Affect is the specific quality of ‘goodness’ or ‘badness.’ It is a feeling that occurs rapidly and automatically, often without consciousness. Investors prefer stocks with positive affect and their preference boosts the prices of stocks with positive affect and depresses their returns.

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