The Effects Of Government Sponsored Enterprise Status On The Pricing Of Bonds Issued By The Federal Farm Credit Banks Funding Corporation

Wang, Yiwo. 2011. The Effects Of Government Sponsored Enterprise (Gse) Status On The Pricing Of Bonds Issued By The Federal Farm Credit Banks Funding Corporation (Ffcb). Doctoral Dissertation, Cornell University.

This thesis develops a framework to price the implicit government guarantee embedded in the bonds issued by the Farm Credit System. It shows that the value of the implicit government guarantee for a specific bond is dependent on the yield spread, the risk-free interest rate, the maturity and the future value of the bond price. It also reconfirms Merton's theory (1974) that yield spreads are influenced by variances of the firm (volatility square), maturity and quasi debt to collateral value ratio (d-ratio). Furthermore, the hypothetical bond yields for the Farm Credit System bonds without GSE status are calculated based on the Black-Scholes Model.

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Essays On The Specification Testing For Dynamic Asset Pricing Models

Yun, Jaeho. 2009. Essays On The Specification Testing For Dynamic Asset Pricing Models. Doctoral Dissertation, Cornell University.

This dissertation consists of three essays on the subjects of specification testing on dynamic asset pricing models. In the first essay (with Yongmiao Hong), "A Simulation Test for ContinuousTime Models", we propose a simulation method to implement Hong and Li's (2005) s transition density-based test for continuous-time models. The idea is to simulate a sequence of dynamic probability integral transforms, which is the key ingredient of Hong and Li's (2005) test. The proposed procedure is generally applicable s whether or not the transition density of a continuous-time model has a closed form and is simple and computationally inexpensive. A Monte Carlo study shows that the proposed simulation test has very similar sizes and powers to the original Hong and Li's (2005) test. Furthermore, the performance of the simulation test s is robust to the choice of the number of simulation iterations and the number of discretization steps between adjacent observations. In the second essay (with Yongmiao Hong), "A Specification Test for Stock Return Models", we propose a simulation-based specification testing method applicable to stochastic volatility models, based on Hong and Li (2005) and Johannes et al. (2008). We approximate a dynamic probability integral transform in Hong and Li's s (2005) density forecasting test, via the particle filters proposed by Johannes et al. (2008). With the proposed testing method, we conduct a comprehensive empirical study on some popular stock return models, such as the GARCH and stochastic volatility models, using the S&P 500 index returns. Our empirical analysis shows that all models are misspecified in terms of density forecast. Among models considered, however, the stochastic volatility models perform relatively well in both in- and out-of-sample. We also find that modeling the leverage effect provides a substantial improvement in the log stochastic volatility models. Our value-at-risk performance analysis results also support stochastic volatility models rather than GARCH models. In the third essay (with Yongmiao Hong), "Option Pricing and Density Forecast Performances of the Affine Jump Diffusion Models: the Role of Time-Varying Jump Risk Premia", we investigate out-of-sample option pricing and density forecast performances for the a¢ ne jump diffusion (AJD) models, using the S&P 500 stock index and the associated option contracts. In particular, we examine the role of time-varying jump risk premia in the AJD specifications. For comparison purposes, nonlinear asymmetric GARCH models are also considered. To evaluate density forecasting performances, we extend Hong and Li's (2005) specification s testing method to be applicable to the famous AJD class of models, whether or not model-implied spot volatilities are available. For either case, we develop (i) the Fourier inversion of the closed-form conditional characteristic function and (ii) the Monte Carlo integration based on the particle filters proposed by Johannes et al. (2008). Our empirical analysis shows strong evidence in favor of time-varying jump risk premia in pricing cross-sectional options over time. However, for density forecasting performances, we could not find an AJD specification that successfully reconcile the dynamics implied by both time-series and options data.

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Essays On Asset Pricing: Predictability, Information, And Liquidity

Chen, Qingqing. 2009. Essays On Asset Pricing: Predictability, Information, And Liquidity. Doctoral Dissertation, Cornell University.

This dissertation is a collection of essays on Asset Pricing: Predictability, Information, and Liquidity. The first chapter, Predictability of Equity Returns over Different Time Horizons: A Non-parametric Approach? aims to test an important hypothesis in financial economics: whether equity returns are predictable over various horizons? We first propose a non-parametric test to examine the predictability of equity returns, which can be interpreted as a signal-to-noise ratio test. Our empirical results show that the short rate, dividend yields and earnings yields have good predictability power for both short and long horizons, which is different from both the conventional wisdom and Ang and Bekaert (2007). Also, using our non-parametric test, a comprehensive in-sample and out-of-sample analysis documents that the predictor variables (dividend yields, earnings yields, dividend payout ratio, short rate, inflation, book-to-market ratio, investment to capital ratio, corporate issuing activity, and consumption, wealth, and income ratio) have predictability power on equity returns but this cannot be well captured by linear prediction models. In addition, we use the nonparametric test to compare the conventional long-horizon prediction regression models on predictor variables with the historical mean model, where there has exists a debate about which model has better forecasting power for equity returns (Campbell and Thompson (2007) and Goyal and Welch (2007)). We find that the prevailing prediction model has a better forecasting power than the historical mean model because the former has a lower neglected signal-to-noise ratio. Finally, we find that our nonparametric predictive models have lower RMSE than the historical mean model at both short-horizon and long-horizon. Using our non-parametric methods, both combined and individual forecast outperform the historical average. The second chapter, An Intraday Analysis of Related Investment Vehicles Traded in the NYSE and AMEX? undertakes an intraday analysis of related, investment vehicles traded in the NYSE and AMEX. I investigate how the trading behaviors of three related investment vehicles (American Depository Receipt, Exchange-traded Fund, and Closed-end Fund) differ across countries using high-frequency intraday data. I ?nd that ADRs trade at transaction prices that are on average worse than ETFs and CEFs. The trading of ADRs, ETFs, and CEFs follows positive feedback strategies. The buy and sell trades of the three securities are driven by the net order imbalances and past returns of three securities themselves. The correlated trading behaviors of the three securities can be explained by momentum traders with a common information set. The third chapter, “Endogenous Information Acquisition, Cost of Capital, and Comovement of Equity Returns” investigates endogenous information acquisition, , cost of capital, and comovement of equity returns. The traditional asset pricing model cannot provide a good explanation for the comovement of asset returns. This chapter introduces endogenous costly information acquisition that generates comovement of asset returns in a rational expectations framework. The private information signals observed by many investors contain information not only about the value of the asset itself, but also the value of many other assets. This common source of information causes excessive covariance in their returns. If informed investors acquire more private information, or more investors are informed, the comovement of asset returns will increase. On the other hand, if informed investors aggressively obtain abundant private information, the comovement will decrease. We also find that both greater precision in private information and higher cost of information will increase a company cost of capital’s.

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Essays On Asset Pricing Models: Theories And Empirical Tests

Li, Yan. 2009. Essays On Asset Pricing Models: Theories And Empirical Tests. Doctoral Dissertation, Cornell University.

This dissertation contains three chapters. Chapter one proposes a nonparametric method to evaluate the performance of a conditional factor model in explaining the cross section of stock returns. There are two tests: one is based on the individual pricing error of a conditional model and the other is based on the average pricing error. Empirical results show that for value-weighted portfolios, the conditional CAPM explains none of the asset-pricing anomalies, while the conditional Fama-French three-factor model is able to account for the size effect, and it also helps to explain the value effect and the momentum effect. From a statistical point of view, a conditional model always beats a conditional one because it is closer to the true data-generating process. Chapter two proposes a general equilibrium model to study the implications of prospect theory for individual trading, security prices and trading volume. Its main finding is that different components of prospect theory make different predictions. The concavity/convexity of the value function drives a disposition effect, which in turn leads to momentum in the cross-section of stock returns and a positive correlation between returns and volumes. On the other hand, loss aversion predicts exactly the opposite, namely a reversed disposition effect and reversal in the cross-section of stock returns, as well as a negative correlation between returns and volumes. In a calibrated economy, when prospect theory preference parameters are set at the values estimated by the previous studies, our model can generate price momentum of up to 7% on an annual basis. Chapter three studies the role of aggregate dividend volatility in asset prices. In the model, narrow-framing investors are loss averse over fluctuations in the value of their financial wealth. Persistent dividend volatility indicates persistent fluctuation in their financial wealth and makes stocks undesirable. It helps to explain the salient feature of the stock market including the high mean, excess volatility, and predictability of stock returns while maintaining a low and stable risk-free rate. Consistent with the data, stock returns have a low correlation with consumption growth, and Sharpe ratios are time-varying.

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Essays On Prospect Theory And Asset Pricing

Yang, Liyan. 2010. Essays On Prospect Theory And Asset Pricing. Doctoral Dissertation, Cornell University.

The financial markets are full of puzzles. In the aggregate market, stocks earn returns that cannot be justified by individual risk aversion (the equity premium puzzle); stock prices fluctuate much more than the underlying dividend process (the excess volatility puzzle); and stock returns can be predicted by many variables, such as dividend-to-price ratios or book-to-market ratios (the predictability puzzle). In the cross-section of stock returns, when stocks are sorted into different groups according to certain economic variables, including prior returns (the momentum puzzle), book-to-market ratio (the value premium puzzle), and size (the size puzzle), one group tends to earn higher average returns than another. At the individual trading level, a large body of evidence suggests that investors are reluctant to take losses (the disposition effect), tend to hold under-diversified portfolios (the under-diversification puzzle), and trade more than can be justified on rational grounds (the excessive trading puzzle). None of these facts can be explained by the traditional consumption-based asset pricing models; they are thus labeled as anomalies. This study explores how models incorporating prospect theory preferences can improve our understanding of asset prices at both the aggregate market and individual stock levels. Chapter 1 studies a market-selection problem in an economy populated by Epstein-Zin investors and prospect theory investors. This chapter answers the questions of whether prospect theory investors can survive and have price impact in the long run, and thus, this chapter lays down the foundation for using prospect theory preferences to understand financial markets. Chapter 2 examines the implications of prospect theory preferences for the disposition effect, the momentum effect in the cross-section of stock returns, and the correlation between returns and volumes. Chapter 3 first provides strong empirical evidence for volatility clustering in the dividend growth rate process and then incorporates this feature into an asset pricing model with prospect theory investors to explore its implications for the aggregate stock market.

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Empirical Tests of Asset Pricing Models in Finnish Stock Market

This study investigates the relationship between different sorts of risk and return on six Finnish value-weighted portfolios from the year 1987 to 2004. Furthermore, we investigate if there is a large equity premium in Finnish market. Our models are the CAPM, APT and CCAPM. Forthe CCAPM we concentrate on the parameters of the coefficient of the relative risk-aversion and the marginal rate of intertemporal substitution of consumption, whereas for the CAPM we estimate the market beta and for the APT we will select some macroeconomic factors apriori. The main contribution of this study is the use of General Method of Moments (GMM). We implement it to all of our models. We conclude that the CAPM is still a robust model, but we find also support for theAPT. In contradiction to majority of studies, we are able to get theoretically sound values for the CCAPM’s parameters. The risk-aversion parameters stay below two and the marginal rate of intertemporal substitution of consumption is close to one. The market beta is still the most dominant risk factor, but the CAPM and APT are as good interms of explanatory power.

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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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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 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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Empirical Studies on Asset Pricing and Banking in the Euro Area

In dit proefschrift staan de aandelenmarkten uit het eurogebied centraal. De belangrijkste conclusie, die als rode draad door het proefschrift loopt, is dat het Europese integratieproces een aantoonbare invloed heeft op de Europese aandelenmarkten. Deze these wordt vanuit verschillende perspectieven onderzocht. Nieuwe modellen voor de waardering van aandelen Een direct gevolg van deze algemene conclusie is dat modellen die gebruikt worden om de prijs van een aandeel te bepalen opnieuw bestudeerd moeten worden. Deze worden namelijk meestal getest op basis van een lange reeks van historische gegevens. Het is echter niet verstandig de verwachtingen te baseren op de historische gegevens alleen, omdat “de spelregels” in en tussen de aandelenmarkten uit het eurogebied veranderd zijn. Bijvoorbeeld, de introductie van de euro heeft als direct gevolg dat het wisselkoersrisico tussen eurolanden is verdwenen. Moerman test één van de meest gebruikte modellen voor het prijzen van aandelen (gebaseerd op het onderzoek van Fama en French) en laat zien dat het Europese model steeds meer terrein wint ten opzichte van een apart model voor ieder land. Hieruit kan geconcludeerd worden dat aandelenmarkten meer financiële integratie laten zien. Betere risicospreiding over sectoren dan over landen Veel pensioenfondsen en andere vermogensbeheerders proberen hun aandelenportefeuille zo slim mogelijk op te zetten door de beleggingen te spreiden, waardoor de verhouding tussen het rendement en het risico beter is. Onderzoek uit de jaren negentig toonde aan dat een spreiding over verschillende landen het meest succesvol was. Moerman laat echter zien dat deze resultaten heden ten dage niet meer opgaan voor het eurogebied. Door het integratieproces laten de aandelenindices van landen steeds meer dezelfde beweging zien, waardoor het spreiden minder diversificatievoordelen oplevert. Spreiding over verschillende sectoren is verstandiger. Gevolgen van deze andere aanpak Uit een rapport van de Europese Centrale Bank blijkt dat veel institutionele beleggers inderdaad hun landenaanpak voor het eurogebied hebben omgezet naar een sectoraanpak. Een direct gevolg hiervan is dat de portefeuillemanagers van deze investeerders, die proberen de index te verslaan, nu worden afgerekend op een sectorindex in plaats van een landenindex. Daardoor neemt de vraag naar de grotere bedrijven binnen een sector toe, omdat de portefeuillemanagers meestal niet teveel van de index mogen afwijken. In zijn proefschrift onderzoekt Moerman dit voor de Europese bankensector. Het blijkt dat de grotere aandelen in de bankensector inderdaad steeds meer op elkaar gaan lijken qua rendementen. Dit kan niet verklaard worden door de resultaten van banken, aangezien deze sterk verschillen, maar lijken dus afkomstig te zijn van veranderingen in de vraag door de wijziging in aanpak van grote beleggers. Dit geeft derhalve een extra motivatie voor banken om door middel van fusies tot het topsegment te behoren. “Een mogelijke strategie voor banken is om te streven bij de grootste banken binnen Europa te horen om zodoende goedkoper toegang tot kapitaal via de financiële markten te krijgen”, zo stelt Moerman. “Dit geeft een verklaring voor de overnamepogingen die momenteel plaatsvinden in deze sector, zoals het bod ABN op Antonveneta en de geruchten tussen HVB en Unicredito”.

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Empirical Studies on Financial Markets: Private Equity, Corporate Bonds and Emerging Markets

This dissertation consists of five empirical studies on financial markets. Each study can be read independently and covers a specific market, either private equity, corporate bonds or emerging markets. The first study documents that risk factors cannot account for the significant excess returns of selection strategies based on value, momentum or earnings revisions indicators in the emerging equity market. The second study presents empirical evidence that security analysts do not efficiently use publicly available macroeconomic information in their earnings forecasts for emerging markets’ companies. The third study focuses on the emerging currency market and shows that a combination of macroeconomic variables and technical trading rules can be exploited to implement profitable trading strategies. Combining these two types of information improves the risk-adjusted performance. In the study on the corporate bond market we document that common risk factors do a good job in explaining the cross-section of returns on corporate bond portfolios with medium to long maturity, but significantly underestimate the returns on corporate bonds with a short maturity. Comparable evidence of a short-term corporate bond anomaly also shows up in portfolios of corporate bond mutual funds. In the last study we set out a commitment strategy that allows an investor in private equity to maintain a constant portfolio allocation to private equity given the uncertain nature of future cash flows and the limited liquidity.

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Model Fama dan French Sebagai Pembentukan Portofolio Saham di Indonesia

EMPIRICAL TESTS OF ASSET PRICING MODELS IN FINNISH STOCK MARKET

Mauri Paavola

LAPPEENRANTA UNIVERSITY OF TECHNOLOGY

School of Business Finance

Helsinki, October 30th, 2007

Porvoonkatu 1 D 133

00510 Helsinki

+358 50 588 0826

ABSTRACT

This study investigates the relationship between different sorts of risk and return on six Finnish value-weighted portfolios from the year 1987 to 2004. Furthermore, we investigate if there is a large equity premium in Finnish markets. Our models are the CAPM, APT and CCAPM. For the CCAPM we concentrate on the parameters of the coefficient of the relative risk-aversion and the marginal rate of intertemporal substitution of consumption, whereas for the CAPM we estimate the market beta and for the APT we will select some macroeconomic factors a priori.

The main contribution of this study is the use of General Method of Moments (GMM). We implement it to all of our models. We conclude that the CAPM is still a robust model, but we find also support for the APT. In contradiction to majority of studies, we are able to get theoretically sound values for the CCAPM’s parameters. The risk-aversion parameters stay below two and the marginal rate of intertemporal substitution of consumption is close to one. The market beta is still the most dominant risk factor, but the CAPM and APT are as good in terms of explanatory power.

Key words:

Stochastic Discount Factor (SDF), Capital Asset Pricing Model (CAPM), Arbitrage Pricing Theory (APT), Consumption-based Capital Asset Pricing Model (CCAPM), Equity premium puzzle, General Method of Moments (GMM)

INTRODUCTION

The economic theory of capital asset pricing relies heavily on the principles of present value calculations and the hypothesis of efficient capital markets. The former tells us that the price of an asset is a function of the expected future yields discounted to the current date. This should apply to all assets, such as stocks, land, houses and durables, since they are alternative investment objects. (Takala & Pere, 1991) In particular, modern financial theory is founded on three central assumptions: markets are highly efficient, investors exploit arbitrage opportunities and investors are rational. (Dimson & Mussavian, 1999).

An important body of research in financial economics has been the behavior of asset returns and especially the forces that determine the prices of risky assets. There are also a number of competing theories of asset pricing. These include the original capital asset pricing models (hereafter CAPM) of Sharpe (1964), Lintner (1965) and Black (1972), the intertemporal models of Merton (1973), Long (1974), Rubinstein (1976) and Cox et al. (1985), the consumption-based asset pricing theory (hereafter CCAPM) of Breeden (1979); Lucas (1978) and the arbitrage pricing theory (hereafter APT) of Ross (1976).

Breeden (1979) and Lucas (1978) took a different approach in defining equilibrium in capital markets. They are able to show, under certain assumptions, that return on assets should be linearly related to the growth rate in aggregate consumption if the parameters of the linear relationship can be assumed to be constant over time (Elton et al., 2007). Breeden (1979) and Lucas (1978) models are so called “representative” agent models of asset returns in which per capita consumption is perfectly correlated with the consumption stream of a typical investor. In this type of models, a security’s risk can be measured using the covariance of its return with per capita consumption (Kocherlakota, 1996).

The CAPM is by far the most famous asset pricing model. It is widely used and examined both in literature and in practice. However, the CAPM is only a description of the reality. By this we mean that the CAPM does not help us understand what the ground factors are and how they affect the risky returns. If we want to go deeper and try to understand what the affecting forces are, how the investors define the returns for the risky assets, we have to start from the basic utility theory and try to find the solution from there.2 The intuitive model to examine is the CCAPM, where the return is given with the covariance of investor’s marginal utility. Moreover, in contrast to the CAPM, intertemporal general-equilibrium models identify clearly the economic forces that influence the risk-free real interest rate and the compensation that investors earn by accepting risk.3 (Carmichael, 1998).

Objectives and methodology

The purpose of this thesis is to find out what the affecting forces behind the stock returns are, and which of these risk factors are significant. We will test the traditional market beta of the CAPM and some other macro-economic risk factors employed in the APT. For the CAPM and APT our focus is on the risk factors (betas), whereas for the CCAPM we will focus on the risk-aversion and discount factor parameters, γ and β. Our purpose is to compare all of these models. We will also try to find reasonable values for the CCAPM’s parameters that have failed numerous times in empirical studies. Our focus will be on the CCAPM, because it is the least known from these asset pricing models. The CAPM and APT serve more as a benchmark models, although we are going to present them in detail. The results of testing the different models are quite inconclusive. CAPM is widely used and its functions are well documented. On the other hand, there is a big group of researchers5 that say that the CCAPM and its consumption beta should be preferable on theoretical grounds, although its empirical testing has failed numerous times.

We will employ Lucas (1978) study for testing the CCAPM with the standard Constant Relative Risk-aversion (hereafter CRRA) power utility function. We will examine a developed stock market of Finland and try to explain the differences in the returns of value-weighted portfolios. The other purpose of this thesis is to examine the equity-premium puzzle emerged from the fact that the consumption tends to be too smooth. Mehra & Prescott (1985) presented the equity-premium puzzle and this rock solid evidence against the CCAPM is still unsolved.

These differences in our value-weighted portfolio returns should be explained only by the different risk factors and the sensitivities of returns to the risk factors according to the theory. In the CAPM the expected equity premium (excess return) is proportional to market beta. The APT relates the expected rate of return on a sequence of primitive securities to their factor sensitivities, suggesting that factor risk is of critical importance in asset pricing. In comparison, the standard CCAPM measures the risk of a security by the covariance of its return with per capita consumption. (Elton et al., 2007)

Most of the empirical tests of these models have been conducted for developed markets, e.g., U.S. and Germany. This study will examine the stock market of Finland. To the best of our knowledge, the Finnish stock market has not been examined this way. There are tests of the CCAPM and of course of the CAPM and APT, but no comparisons of these models in the same data set. We will compare the realized asset returns within these models to see which model provides the best results of explaining the time-series variation of value-weighted stock portfolios.

One of the main contributions of this thesis is the use of the Generalized Method of Moments (hereafter GMM) method. Again, to the best of our knowledge, this method has not been used in this way for the Finnish data, i.e., comparing these asset pricing models in the same data set. We will employ the GMM to all of our empirical tests and make comprehensive conclusions of the asset pricing models’ ability to explain the portfolio returns. The GMM is a general statistical method for obtaining estimates of parameters of statistical models and it is widely used in the finance literature. All the empirical tests are done with Matlab.

Limitations and motivations

This study is performed from the European investor’s point of view so that the currency used in this study is euro and also risk-free rate is quarterly Euribor. In selecting the factors for our different models we will choose them a priori, as in Chen et al. (1986). The data used in this study is gathered from ETLA, Research Institute of the Finnish Economy, and Data- stream. The research period will be from the beginning of the year 1987 to the end of year 2004.

We will test the asset pricing models in their purest form. This means that, e.g., the CCAPM is tested as it was presented in Lucas (1978). Thus, we will not use any other implications of the CCAPM that are, e.g., the habit formation of Constantinides (1990), the “non-expected utility” preferences of Epstein and Zin (1989) or the investment-based asset pricing model of Cochrane (1996), to name a few. However, these studies are important because they had had some success in solving the problems of the CCAPM and the key results are presented in this thesis. We are well aware that doing this thesis in this way, without any further assumptions or modifications of the CCAPM, may lead to a rejection of the CCAPM. This is probably the case, because we know that Finnish stock market has a relatively high equity premium, especially in our research period.9 How- ever, we also know that other models that we presented above have not had success in solving the equity premium puzzle, at least not in different markets, data sets, etc. Thus, right now we do not have an explicit solution to the equity premium puzzle, which we will show in further chapters.

Structure

The thesis is structured as follows. The next chapter introduces the basics of the utility theory and the concept of Stochastic Discount Factors (SDF). The third and fourth chapter presents the different asset pricing models in great detail and also one of the biggest debate issues in earlier studies, the determination of relevant factors, is represented. We will separate the discussion between the CAPM/APT and the CCAPM, because our main focus in on the less known CCAPM. Furthermore, the CAPM and APT are quite alike models, but the CCAPM comes from totally different grounds. In the fifth chapter we will go through some of the basic problems associated with the asset pricing models and go through an extensive amount of previous empirical studies. The sixth chapter describes the data for our purposes. We will especially concentrate on the research methodology, because we have found out that there are a lot of different methods to choose from. Furthermore, the GMM is explained in a difficult way and also quite irrationally in many parts of the literature, although it is a quite simple and effective method. The seventh chapter reports the empirical results and findings. The final chapter is for conclusions and suggestions for further research.

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Financial integration in the EMU: The Fama and French Factors in the Euro zone

H.W.C. Vreedenburgh

ERASMUS UNIVERSITY ROTTERDAM

ERASMUS SCHOOL OF ECONOMICS

MSc Economics & Business

Master Specialisation Financial Economics

July 2010

ABSTRACT

Integration in the EMU stock markets has some major implications for investors, their international portfolio diversification possibilities and the way they should price stocks. This paper will add an insight and provide evidence in the discussion whether or not the EMU stock market is can regarded as an integrated market, and what this means for the way stocks should be priced. This paper’s main contribution is providing evidence of EMU stock market integration by using a non-correlation method and asset pricing models, and what asset pricing model is able to price the stocks best in the integrated EMU zone. Using the principal component analysis, we have shown that there is an increasing degree of integration in the EMU zone. Although the rate of the smaller EMY countries is higher, the larger EMU countries were already quite integrated.This article also uses local, EMU and combined (EMU and local) factor models to see which model is able to price EMU stocks as a way of testing integration. We show that the Fama and French three factor model is better at pricing stocks for individual countries better than CAPM. This article shows that the EMU factors are doing quite well on pricing stocks, especially in the larger countries, although local factors still have an impact. Considering different time frames, we see that the local factors have lost much of their additional explanatory power in the post-2001 period. Finally, this paper shows that an EMU factor model is able to price all EMU stocks better than countries individually.

Keywords:  Asset pricing, Portfolio Choice, International Financial Markets, Financial Aspects of Economic Integration

JEL: F36, G11, G12, G15

Introduction

After the completion of the European Economic and Monetary Union (EMU), with the signing of the Maastricht Treaty in 1992, and eventually the introduction of the euro in 1999, Europe is supposed to have seen a remarkable economic integration ever since. As the euro was only introduced relatively recently, there are still limited academic studies on what impact the EMU (and the introduction of the euro) has on the EMU stock market, the integration of the EMU stock markets and its impact on stock pricing alone.

Integration in the EMU equity markets has some major implications for investors, their international portfolio diversification possibilities and the way they should price stocks.

This paper will add an insight and provide evidence in the discussion whether or not the EMU stock market can be regarded as an integrated market, and what this means for the way stocks should be priced.

This paper’s main contribution is providing evidence of EMU stock market integration by using a non- correlation method and asset pricing models, and to show what asset pricing model is best to price the stocks in the integrated EMU zone.

 The structural changes in the financial markets of the EMU zone have resulted in a changing approach to the use of EMU stocks in international portfolio management. An integrated European market could have a major impact on the way investors price stocks and how to achieve a well-diversified portfolio.  Although the size of the EMU equity market is - compared to the United States- not that big in terms of global market value, it has attracted a large number of non-EMU investors for its diversification benefits.

These investors have looked for opportunities to reduce portfolio risk by investing in stocks across different national markets where low correlations in return exist, while keeping the expecting return at the same level.

However, the assumed integration process of the EMU zone could potentially limit these benefits, as correlations between the EMU countries will rise. This could result in new optimizations in the commonly used mean-variance frontier in modern portfolio theory (Markowitz, 1952) for investors in the EMU zone.

On the other hand, the integration will lead to new opportunities and policies. The integration of the EMU stock market could result in one big investment area instead of several different ones, resulting in better risk sharing benefits, improvements in allocation efficiency and a reduction in economic volatility (Baele et al., 2004).

The creation of the EMU made it also possible for investors to buy EMU stocks without any limitations, as it is supposed to be a single market. Often, (institutional) investors were often restricted (for a  certain amount) to a certain country (or currency). This limitation could be removed if the EMU appears to be actually one single market. This could result in more investments in the EMU zone. It could also limit the question which EMU country is a better option, as the EMU zone will appear as one investment opportunity, and shifts the question to which industry in the EMU is a better investment.

In this paper we assume that the integration in the EMU market means that every stock within the EMU countries is subject to same (financial) circumstances and sensitive to the same (financial) shocks, regardless of the country in which they are traded. There should be no market frictions within the EMU stock markets and EMU countries.

This means that every investor in the EMU has the same opportunity set, the same limitations, same costs and risks when investing in stocks. We consider this as a fair expectation of an integrated market, however, we will look for evidence to support this assumption.

If this is the case (which we expect), then it is interesting to know if the stocks could be priced by the same risk factors, which could indicate if the market is really integrated. Do national risk factors still add something to the pricing of EMU stocks? Or is one EMU risk factor able to price all EMU stocks?

If we think about risk factors, it is a logical step to come to the Capital Asset Pricing Model (CAPM). At present, the CAPM is a model which probably is the most widely used model to price assets in the financial market. Even in the corporate world the CAPM is present, as it is the foundation to calculate the cost of equity. Hence it has a major impact in calculating the Weighted Average Cost of Capital (WACC), as the cost of equity is directly related to CAPM (investors want compensation for being exposed to none diversifiable risk) (Arzac, 2005).

The CAPM is presumed that in a case of a fully integrated market, with the assumption that purchasing power parity holds, CAPM should be able to price all assets (Grauer et al., 1976).

From the ‘basic’ CAPM - a one factor model - the multifactor extension by Fama and French is the most widely used (1992, 1993, 1995, 1996, 1998); the Fama and French Three Factor Model (3FM). They showed in their papers that the two variables (risk factors) ‘size’ and ‘value’ add to the explanatory power of the model. So it is interesting to see how the CAPM and 3FM perform in an integrated EMU market.

In this paper we will compare the two models and see if they are able to price the EMU countries and the EMU zone as a whole. As both models are based on the same principle, it is easy to compare them and it is interesting which one significantly performs better at pricing the European market.

This paper could also contribute to the methodological discussion on which asset pricing models perform better. Although most academic papers provide evidence that the 3FM performs better than CAPM, most research has been focused on the United States (US) and on European countries individually (the United Kingdom in particular). Limited articles are written about the EMU as a whole or on the EMU countries together. This is mostly because of the lack of data, different currencies before the euro and the small number of stocks in many European countries.

The creation of the EMU created potentially a new data area in which different theories could be tested, besides the UK, Japan and the US. The empirical results in this paper could contribute to the discussion if the models are able to explain the returns of stocks and possibly add support for (one of) the models. At first, we will look (a) if there is evidence for the stock markets of the 12 initial EMU countries (which do not contain current EMU members Cyprus, Malta, Slovenia and Slovakia) to be integrated.  We will use the principal component analysis (PCA) for the EMU zone in order to see if the equity markets in the EMU equities are correlated with the first principal component.

By doing this we want to find evidence which supports our assumption that the EMU zone is integrated and is subject to (some of) the same financial circumstances. Also we want to see what the impact of the EMU is on the integration in the EMU stock markets.

Secondly, we will construct the CAPM and the Fama and French three factor model (3FM) for the 12 EMU countries and for the EMU zone as a whole. We will compare the results in order to see if the CAPM is better a pricing EMU stocks then 3FM (b) when using national factors and (c) when using EMU factors.

We also add national factors to the EMU CAPM and 3FM to see (d) if the addition of these factors to an EMU 3FM has any significant impact. We can look if the EMU risk factors are able explain the returns, which could be evidence for EMU integration in the stock markets. We will look (e) if there is evidence that the EMU got more integrated after 2001 by looking at the impact of national factors in the asset pricing models.

Finally, we will look (f) for evidence if the EMU factors are able to price the EMU zone as a whole. We will test the PCA for the period January 1992 until December 2009, while the CAPM and 3FM will be tested for the period of July 1993 until June 2009 by using the adjusted R2 and – only for the CAPM and 3FM - the pricing error α (Jensen, 1968).

This paper is structured as follows. Section 2 will provide background information and a review of prior research. Section 3 describes the data employed. Section 4 defines the methodology used. Section 5 shows how the risk factors are constructed. Section 6 presents the descriptive statistics used and the results. Finally, section 7 will conclude the paper.

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