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Spring 1996
Introduction
Modern theory of investment in financial assets, as opposed to investment in real and derivative assets, has embraced three main building blocks of continued development and refinements. It spans three decades from 1950s to 1970s namely, the portfolio theory and the single-factor model which are based on the mean-variance efficiency (MVE) for assets allocation pioneered by Markowitz (1952, 1959) and simplified by Sharpe (1963), the capital asset pricing model (CAPM) developed independently by Sharpe (1964), Lintner (1965), and Mossin (1966), and the arbitrage pricing theory (APT) by Ross (1976). While the MVE is concerned with the diversifiability of idiosyncratic risk associated with the expected rates of return on securities through optimal portfolio selection, the CAPM is more involved with the estimation of the general-equilibrium rates of return on securities in relation to the term structure of the risk-free interest rate and the non-diversifiable market risk premium. In particular, both MVE and CAPM rely on the second moment of the stochastic return-generating function, i.e., variance (2) and standard deviation (), as the measures of risk. In general, however, the proxies for risk can be derived from factors other than variance-covariance relationship between the market and the specific security as extended by the APT. All these three interrelated theories and models shall be explored in more detail in the sections to follow. The interim section investigates the empirical tests of CAPM and APT. My own conclusion and critique are supplied in the final section of this paper.
Using the Lagrangian optimization technique with two multipliers, and , the resultant portfolio weight is given by: w = (V-1e) + (V-11) Further manipulation of matrix algebra yields: w = D-1[B(V-1)-A(V-1e)] + D-1[C(V-1e)-A(V-11)]E where: A B C D = = = = (e V 1) (eTV-1e) (1TV-11) (BC-A2)
T
and:
-1
= =
D-1(CE-A) D-1(B-AE)
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where:
rj j ji Fi j E[j] = = = = = = ex ante rate of return on security j non-factor-related rate of return on security j sensitivity of the return on security j to the ith factor value of the ith factor, i = 1,2,...,k residual return uncorrelated with any factors in the model zero
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j = bj1F1 + bj2F2 + ... + bjkFk where: j Fi bji = = = beta of security j to the change in market portfolio return beta of the ith factor to the change in the market return, i = 1,2,...,k sensitivity of bj to bFi
If expected returns are generated by a k-factor model, j in the CAPM becomes the terms on the right-hand side of the above equation. Thus, the k-factor CAPM is given by: E[rj] = rf + (E[rm] - rf)(bj1F1 + bj2F2 + ... + bjkFk) E[rj] = rf + bj1{(E[rm]-rf)F1} + bj2{(E[rm]-rf)F2} + ... + bjk{(E[rm]-rf)Fk} where: rf = 0 (E[rm]-rf)bFi = i, i = 1,2,...,k Chamberlain and Rothschild (1983) offer a generalization of the APT with an approximate factor structure with the no-arbitrage assumption being replaced by the assumption that the price functional () is continuous. Reisman (1988) provides a simple proof of the generalized APT using the Hahn Banach theorem when the security payoffs have an approximate factor structure. He concludes that the general formulation of the APT which allows an infinite dimensional factor space may be use in the extension of the theory to the dynamic case. Even with Reisman's proof, the use of the mathematical theory of Banach is still far beyond layperson's understanding. Until recently, Shanken (1992) supplies an alternative proof of Reisman's result. The conclusion of Reisman's proof is that the infinite space of expected returns is approximately equal to some linear function of the securities' factor betas. Shanken attempts to show that if the betas on factors (F) are approximately proportional to the betas on a proxy (P), then expected returns are approximately equal to a linear function of the betas on P. The factor representation for the first N security returns is given in vector form as: rN = a*N + bNF + N
where:
E[N] = Cov(N,F) = 0 Let CN be the N x N covariance matrix for N and let u be an upper bound on the Eigen values of CN. By the approximate factor model assumption, u can be taken to be independent of N. Theorem: If returns conform to an approximate factor structure and there is no arbitrage, then expected returns are approximately linear in the betas on any proxy that is correlated with the factor. Lemma 1: Let p be the residual from a regression of P on F and a constant, and let dN be the N-vector of covariance between p and the components of N. Then d_NdN Var(p)u. Lemma 2: If returns conform to an approximate factor structure, then the betas on P are approximately proportional to the betas on F. If P and F are correlated, then the betas on F are approximately proportional to the betas on P.
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dependence structure of stock prices. Fama and MacBeth (1973) attempt to test expected returns factor model for equilibrium setting. Farrell (1974) analyzes covariance of stock returns to determine the groupings of homogeneous stocks. Rosenberg and Marathe (1975) use multifactor model to estimate and predict systematic and residual risks. Arnott (1980) relies on cluster analysis to identify covariance factors that determine stock price movement. Sharpe (1982) identifies expected returns factors in the NYSE using multifactor model. Estep, Hanson, and Johnson (1983) attempt to find the multiple factors that determine both stock prices and risk. Rosenberg, Reid, and Lanstein (1985) identify book-to-price ratios as another pervasive factor beside market risk premium which influence stock returns. Fama and French (1992, 1995, 1996) add size factor and book-to-price ratios to the CAPM and propose it as the three factor model to explain most of the market anomalies. Haugen and Baker (1996) employ all firms specific factors in their cross-sectional, cross-national factor model and conclude that they are common to all stocks in all major equity markets around the world. As Roll (1977) argues on the CAPM's front, the definitive tests of CAPM can never be performed simply because it is intended to be an ex ante, not ex post, model. Moreover, the definition and measurement of the market portfolio is still doubtful in the sense that whether or not other low-liquidity and non-domestic assets such as real estate, foreign assets, commodity, and collectible items should be or are actually included. His argument is supported by the fact that, even if capital markets are efficient and the CAPM is valid, the cross-sectional SML cannot be used as a means to measure the ex post performance of portfolio selection models as a result of the following realities: 1) 2) 3) 4) Because of various actual trading restrictions such as unlimited riskless borrowing and short-selling, investors may not be able to hold MVE frontier portfolios. Due to the fact that security returns are not normally distributed, investors may have skewness preferences and end up holding inefficient portfolios. Since transaction costs and taxes affect security returns, investors who face different costs may take inefficient portfolio positions gross of cost. Investors may suboptimize their portfolio positions when holding indivisible assets such as their own human capital (i.e., the present value of their future earnings).
To perform the ex post tests, the expectations models must be transformed into the realizations models both in the time-serial and cross-sectional forms: Time-Serial Form rjt - rft = (rmt - rft)j + ejt
where:
e = actual residual returns Cross-Sectional Form
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are persistently related to earnings, while size is more highly related to annual returns than book-to-price ratios. Jaganathan and Wang (1993) argue that betas vary over the business cycle and develop a three-beta model. Fama and French (1996) propose a three factor model which can explain most market anomalies found by CAPM and provide its explanation that multiple common sources of variation in returns are necessary, that investors' irrational behavior may not cause anomalies, and that spurious betas result from survivor bias, data snooping, and bad market proxies. Haugen and Baker (1996) suggest two alternative approaches to tackle market anomalies by using the multiple factor model and the behavioral model. For the first approach, forty-one factors are grouped into six firm characteristics namely, 10 risk factors, 4 liquidity factors, 10 price factors, 9 growth potential factor, 7 technical factors, and 1 sectoral factor. The results are that 1) stocks with higher expected and realized rate of return are lower in risk than stocks with lower returns, 2) important determinants of expected stock returns are common to the major equity markets around the world, and 3) the efficient markets hypothesis should be rejected. Tests of APT, though occurred about ten years later than those of CAPM, are less controversial because the APT itself requires no assumptions about returns distribution, investor preferences, and market portfolio, while being able to predict relative pricing of any subset of securities. Roll and Ross (1980) embark on empirical investigation of APT by looking at daily returns on NYSE and AMEX stocks between 1962 and 1972. After correcting for dependence between mean and standard deviation that lognormality causes, they find that total variance of returns does not add explanatory power to the model. They also find the same result for the intercept term which proves that APT is robust and should not be rejected. Reinganum (1981) forms portfolios of like factors based on previous years' returns and finds excess returns. His conclusion is to reject the APT. Shanken (1982) questions the testability of the APT that 1) since it requires a large number of securities to approximate returns, it may not work on smaller samples, and 2) since the basic construct of APT is the linear factor model, it means that different grouping of stocks may result in different slope coefficients which would be inconsistent. Chen (1983) groups stocks into high-market value and low-market value groups and finds that grouping based on market value is not significant. He also compares the results with those from CAPM and finds that APT explains significant part of CAPM's residual but not vice versa. Chen, Roll, and Ross (1983) use four macroeconomic factors in the APT, i.e., index of industrial production, ratio of inflation, yield spread between T-bonds and BB corporate bonds, and yield spread on short-term and long-term bonds. Connor (1983) tests the Nash or competitive equilibrium APT and finds it can eliminate the need to assume an infinite number of securities for the market portfolio. Roll and Ross (1984) critically reexamine the empirical evidence on the APT and argue that it is testable and can be use in strategic portfolio planning. Dybvic and Ross (1985) address Shanken's critique by noting that returns explained by factor structure in actual securities is much different from returns explained by factor structure in arbitrary portfolios. Wei (1988) uses Nash equilibrium APT by adding market portfolio as another factor which effectively combines CAPM and APT. Robin and Shukla (1991) examine the monthly returns from 1976 to 1985 using the Chicago's Research on Security Prices (CRSP) data and find that pricing errors and variance are high and statistically significant. Chatterjee and Pari (1990) use a non-parametric method to estimate factors for APT and find that the number of factors increase linearly with the number of securities. Shukla and Trzcinka (1990) employ principal components method to identify the factors and find that 40% of variation in returns can be explained in a five-dimensional APT model. Mei (1993) use the data from 1963 to 1990 and find that APT can explain size and dividend yield but fails to explain book-to-price ratios and price-earnings ratios.
Conclusion
It is overwhelming to give a precise conclusion about modern investment theory amid its structural successes and empirical flaws. Yet, without theoretical grounds against which to be contrasted, we would by no means be convinced that there are no simple ways to explain the actual behavior of financial assets' prices and returns. Modern investment theory should be perceived as the indispensable building block for every academician and practitioner to start off, but not to be engrossed, with. Our judgment should be based upon benefit/cost analysis it contributes/incurs to our understanding about and stakes in the real-world investment phenomena. Academically, as Friedman (1953) suggests, theories should be judged not on the basis of their assumptions but rather on the validity of their predictions. Practically, the techniques of modern investment theory have enabled individuals to make their investment decisions wisely with clear purposes and criteria. Thus, it depends on which of the two relative stances we take in order to justify the trade-offs between adopting and rejecting the modern investment theory. Today, we have quite enough empirical evidence to comfortably reject most of the works done during the last forty years. But, such rejection should not mislead us to favor other alternative paradigms altogether for they are also subject to the same destiny as the current ones. As Sharpe (1984) concludes, "While the relative importance of various factors changes over time, as do the preferences of investors, we need not completely abandon a valuable framework within which we can approach investment decision methodically. We have developed a useful set of tools and should certainly continue to develop them. Meanwhile, we can use the tools we have, as long as we use them intelligently, cautiously, and humbly."
References
Adler, M. and B. Dumas (1983) International Portfolio Choice and Corporation Finance: A Synthesis, Journal of Finance. Banz, R.W. (1981) The Relationship between Return and Market Value of Common Stocks, Journal of Financial Economics. Basu, S. (1977) The Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios, Journal of Finance. Breeden, D.T. (1979) An Intertemporal Asset Pricing Model with Stochastic Consumption and Investment Opportunities, Journal of Financial Economics. Brennan, M. (1970) Taxes, Market Valuation and Corporate Finance Policy, National Tax Journal. Black, F. (1972) Capital Market Equilibrium with Restricted Borrowing, Journal of Business.
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Black, F., M.C. Jensen, and M. Scholes (1972) The Capital Asset Pricing Model: Some Empirical Tests, Jensen, ed., Studies in Theory of Capital Markets Praeger, New York. Chamberlain, G. and M. Rothschild (1983) Arbitrage, Factor Structure, and Mean-Variance Analysis on Large Asset Markets, Econometrica. Chen, N.F. (1983) Some Empirical Tests of the Theory of Arbitrage Pricing, Journal of Finance. Chen, N.F., R. Roll, and S.A. Ross (1983) Economic Forces and the Stock Markets, Unpublished Manuscript. Yale University, New Heaven, Connecticut. Curcio, R.J. (1983) Diversification Gains from Including Real Estate in Mixed-Asset Portfolios, Paper presented at the Financial Management Association Annual Meeting. Elton, E. and M.J. Gruber (1987) Modern Portflio Theory and Investment Analysis. John Wiley & Sons, New York, NY. Errunza, V.R. and L.W. Senbet (1981) The Effects of International Operations on the Market Value of the Firm: Theory and Evidence, Journal of Finance. Fama, E. and K. French (1992) The Cross-Section of Expected Stock Returns, Journal of Finance. __________. (1995) Size and Book-to-Market Factors in Earnings and Returns, Journal of Finance. __________. (1996) Multifactor Explanations of Asset Pricing Anomalies, Journal of Finance. Fama, E. and J. MacBeth (1974) Tests of Multiperiod Two Parameter Model, Journal of Political Economy. __________. (1973) Risk, Return and Equilibrium: Empirical Tests, Journal of Political Economy. Friedman, M. (1953) The Methodology of Positive Economics, Essays in Positive Economics. University of Chicago Press, Chicago, Illinois. Friedman, H.C. (1971) Real Estate Investment and Portfolio Theory, Journal of Financial and Quantitative Analysis. Grubel, H.R. (1968) International Diversified Portfolios: Welfare Gains and Capital Flows, American Economic Review. King, B.F. (1966) Market and Industry Factors in Stock Price Behavior, Journal of Business. Kraus, A. and R. Litzenberger (1976) Skewness Preference and the Valuation of Risky and Assets, Journal of Finance. Lakonishok, J, A. Shleifer, and R. Vishny (1994) Contrarian Investment, Extrapolation, and Risk, Journal of Finance. Levy, H. (1983) The Capital Asset Pricing Model: Theory and Empiricism, Economic Journal. Lintner, J. (1965) The Valuation of Risk Assets and the Selection of Risky Investment in Stock Portfolio and Capital Budgets, Review of Economics and Statistics. __________. (1969) The Aggregation of Investor's Diverse Judgements and Preferences in Purely Competitive Markets, Journal of Financial and Quantitative Analysis. Lo, A.W. (1986) Statistical Tests of Contingent-Claims Asset-Pricing Models, Journal of Financial Economics. Markowitz, H.M. (1952) Portfolio Selection, Journal of Finance. __________. (1959) Portfolio Selection: Efficient Diversification of Investment, John Wiley & Sons, New York, NY. Merton, R.C. (1973) An Intertemporal Capital Asset Pricing Model, Econometrica. Mossin, J. (1966) Equilibrium in a Capital Market, Econometrica. Reinganum, M.R. (1981) Misspecification of Capital Asset Pricing: Empirical Anomalies Based on Earnings Yields and Market Values, Journal of Financial Economics. Reisman, H. (1988) A General Approach to the Arbitrage Pricing Theory, Econometrica. Roll, R. and S.A. Ross (1980) An Empirical Investigation of the Arbitrage Pricing Theory, Journal of Finance. Ross, S.A. (1976) The Arbitrage Theory of Capital Asset Pricing, Journal of Economic Theory. Shanken, J. (1982) The Arbitrage Pricing Theory: Is It Testable?, Journal of Finance. __________. (1992) The Current State of the Arbitrage Pricing Theory, Journal of Finance. Sharpe, W.F. (1963) A Simplified Model of Portfolio Analysis, Management Science. __________. (1964) Capital Asset Prices: A Theory of Market Equilibrium, Journal of Finance. __________. (1984) Factor Models, CAPM, and The APT, Journal of Portfolio Management. Statman, M. and H. Shefrin (1994) Behavioral Capital Asset Pricing Theory, Journal of Financial and Quantitative Analysis. Webb, J.R., R.J. Curcio, and J.H. Rubens (1988) Diversification Gains from Including Real Estate in Mixed-Asset Portfolios, Decision Sciences.
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