Journal of Banking and Finance I5 (1991) 449-460.

North-Holland
Risk return and the three-moment capital
asset pricing model: Another look
Kai-Jiaw Tan*
Unicersir!, of Alabama in Huntscille, Huntsville, .4 L 35899. USA
Received March 1990, linal version received September 1990
Most studies on three-moment capital asset pricing models have found a strong and consistent
relationship between an assets returns and its higher statistical moments. Other studies report
results which are opposite to what the theory would suggest. This paper re-examines the
empirical evidence of the three-moment capital asset pricing model on 43 randomly selected
mutual funds from 1970-1986. The results indicate that trade-offs of risks for returns on the
selected mutual funds are less than predicted and inconsistent.
1. Introduction
One of the research areas of the multidimensional capital asset pricing
model and portfolio theory is the relationship between a portfolios returns
and its higher statistical moments. The importance of higher moments in
investors utility function is evidenced in papers by Jean (1971, 1973),
Ingersoll (19754 Scott and Horvath (1980) and Kane (1982). Some empirical
tests of these hypothesized relationships between a portfolios return and its
third statistical moments have been conducted by Arditti (1971), Francis
(1975), Levy and Sarnat (1972), Kraus and Litzenberger (KC!% L) (1976) and
Friend and Westerfield (F&W) (1980), among others. Most of their findings
tend to support the theoretical relationship between the first three statistical
moments. That is, in order to maximize the expected utility of portfolio
return, risk-averters would prefer higher expected return to smaller, smaller
variance to larger, and higher (and positive) third statistical moment about
the mean to lower (and negative), other things being constant. Accordingly,
they are willing to accept a lower expected rate of return or to take a higher
variability risk for a higher positive skewness if the market is also positively
skewed.
In a recent study, F&W (1980) have provided some, but not conclusive,
evidence to support the importance of skewness in the pricing of risky assets.
*The author wishes to thank an anonymous referee for his helpful comments.
037&i266/91/$03.50 Q 1991-Elsevier Science Publishers B.V. (North-Holland)
450 K.-J . Tan, Risk return and three-moment capital asset pricing model
Their findings are substantially different from those of K & L (1976). Because
of the conflicting results obtained by these two studies, it is the primary
purpose of this paper to investigate empirically whether the three-moment
capital asset pricing model (TMCAPM) developed by K&L holds for the
selected mutual funds. If the results hold for mutual funds, systematic risk
and systematic skewness can provide adequate risk measures as proxies for
mutual funds. If they do not hold, perhaps other systematic economic factors
can be used to better explain mutual fund returns. Our results, however,
show that trade-offs of risks for returns in our selected mutual funds are less
than predicted and inconsistent with the TMCAPM.
One of the possible explanations for the inconsistence of skewness in
explaining the returns of securities is that raw skewness is rapidly diversified
away as more securities are formed into a portfolio. What stays in the
portfolio is the systematic skewness. However, the systematic skewness that
remains in the portfolio may not show skewness persistence. If systematic
skewness does not persist even if the market is efficient, systematic skewness
should not explain very much about the returns of the portfolios.3
Section 2 discusses the related literature on skewness and its relationships
with returns and systematic risk. Section 3 describes the data and method-
ology. Section 4 presents the empirical results and a comparison of the
results to those of earlier studies. Section 5 contains the conclusions and the
implications of our findings.
2. Previous studies
In an effort to determine empirically whether investors take skewness into
consideration in their investment decisions, both Arditti (1971) and Francis
(1975) examined the empirical relation of ex post returns to standard
deviation and total skewness. However, their results contradict each other in
that Franciss sign on the estimated skewness coefficient is opposite of
Ardittis and, therefore, opposite of what theory would suggest. Francis
attributed the discrepancy to differences in the differencing time intervals
used. Arditti, on the other hand, gave his plausible explanation for the
contradiction to the fact that they might have misspecitied the regressions
simply because they did not have a model of how skewness precisely enters
the pricing structure.
Until 1976, the theoretical framework of TMCAPM was derived and
Roll and Ross (1984) believe that the following four economic factors are relevant: (a)
unanticipated changes in inflation, (b) unanticipated changes in industrial production, (c)
unanticipated shifts in risk premium, and (d) unanticipated movements in the shape of the term
structure of interest rates.
For an analysis of the diversification effect on skewness, see Simkowitz and Beedles (1978).
For a justilication of this argument, see Singleton and Wingender (1986).
K.-J. Tan, Risk return and three-moment capital asset pricing model 451
tested by Kraus and Litzenberger (1976). The linear empirical version of the
K & L model can be given as
(1)
where
Ri = the expected return from security or portfolio i,
RF = the risk-free rate,
Bi - RF = the expected risk premium of security i,
biM = the systematic risk (beta) of security i
=EC(Ri-~i)(R~-R~)lIEC(R~~-R~)21
= Cov(Ri, bJ/hJ2,
gi, = the systematic skewness (gamma) of security i
=EC(Ri-Ri)(RM-R~)211EC(R~~--~)31
=Cov(Ri, Rh)/(MMJ3,
b. = the mean intercept term,
b, = the estimated market price of beta
=(dR/ds)s,, and
b2 = the estimated market price of gamma
=( -dR/dM)M,.
Eq. (1) can also be expressed theoretically as
Ri-R,=b,+(dR/ds)s,BiM+(-dR,d.M)Mwgiu.
(2)
These two equations show the linear relationship between the expected
return on a security with its systematic risk and its systematic skewness,
given the risk-free rate, the market return, the systematic risk, and the
systematic skewness of the security. Obviously, Arditti and Francis did not
distinguish between total and systematic skewness in their studies. As
indicated by eqs. (1) and (2), the K&L market equilibrium model requires
the systematic skewness rather than the total skewness to be the relevant
variable for the pricing of risky securities.
The TMCAPM was tested more rigorously by F& W (1980) with mixed
results. The TMCAPM was later examined by Sears and Wei (1988). But
they took one step further to identify the fact that the expected risk premium
of security i is also sensitive to the market risk premium. When market risk
premium is explicitly included in eq. (2), it can be rewritten as
452 K.-J. Tan. Risk return and three-moment capital asses pricing model
Table 1
Sampling properties of K,. market risk premium. average beta, and the signs of b,.
Case -dR/dM dR/ds M, $K,
&--RF
PIM =Signs of b,
~-
1
t-1 (+I f+) (+)=(-) (+I - (+)=(+T
2
t-1 (+I t+) (+)=(-I (+I f-)=(-P
3
f-1 (+I (-1 (+)=(+I (+I I+)=(+)
4
f-f (+I f-1 (+)=(+I t+) (-)=(-I
5
;r;
f+) (+I (+I=(--) t--j (+)=(-?
6
f+-) (+) (+I=(-) t-9 (--)=(+-P
7
t-1 t+) f--j (+)=(+I (-1 (+I=(--)
8
f--j I+-) f-1 (+)=(+I I-1 f-i=(+)
The first four columns are assumptions concerning the components of K,. The
next column gives the intermediate results of K,. The other two columns are
assumptions about market risk premium and average beta. The last column provides
the results of b, given in eq. f 1).
bThis is true if - 1 <k, <O.
Table 2
Sampling properties of K,, market risk premium. average gamma, and the signs of
!.?,.a
Case -dR/dM dR,ds MN s,=K,
&4-R,
jlIM = Signs of b,
.--
1
i-1
1+) (+I (+I=(-) (+I (+)=(--lb
2
(+I i-+1 (+I=(-) (+I (-f=f+Ib
3
f-1 (+I f-1 (+I=(+) t+f (+)=(+I
4
f-1 W) (--) f+)=(+) t+) f-J=(-)
5
f-1 t+) f+) (+I=(-) (-1 (+)=f+Jb
6
f-1 (+I f+) (+)=f-) t-1 (-)=(-lb
7
(+I (-1 (+)=t+) t--j (+)=I-)
8
11;
(+I f-1 (+I=(+) i-1 f-l=(+)
The first four columns are assumptions concerning the components of K,. The
next column gives the intermediate results of K,. The other two columns are
assumptions about market risk premium and average gamma. The last column
provides the rest&s of b, given in eq. (1).
Thisis trueif -l<K,<O.
where K 3 = [( -dR/dM)/(dR/ds)](M,/s,), the markets marginal rate of
substitution between skewness and risk times the risk-adjusted skewness of
the market portfolio. K3 turns out to be -(d~/s~)(d~/~~), the cross-
elasticity between standard deviation and skewness. It measures how much
percentage increase (decrease) in standard deviation an investor is willing to
take in exchange for a 1% increase in positive (negative) skewness, other
things being equal. Theoretically, when MH >O, K3 ~0, and vice versa. This
relationship is illustrated in more detail in tables 1 and 2. According to eq.
(3), the TMCAPM predicts: bo=O, b, can be positive or negative depending
on the signs of the variables in table 1, b, can also be positive or negative
depending on the signs of the variables in table 2, and &.,-RF= b, + b,.
Given the facts that the market was negatively skewed over the test periods
with average market risk premium, average beta, and average gamma being
positive, we would expect b, and b, to be positive as shown in Case 3 in
tables 1 and 2, respectively. However, our results of the TMCAPM on
mutual funds are inconsistent with what eq. (3) would predict. First, b, is
significantly different from zero. Second, b, is positive but not significant.
Third, b, is negative and not significant.
As shown in eq. (3), because of the interaction between aM--R, and K, in
the determination of b, and b2, the signs of b, and b, may not give a
clearcut theoretical relationship within such models. Therefore, an examina-
tion of the statistical results in TMCAPM requires a careful specification of
the sampling properties of K,, &,-RF, /?+,, and gi,.
3. Data and methodology
The mutual funds are used in this study because they are managed
portfolios and, therefore, provide an excellent vehicle for risk-return study.
One of the advantages of studying mutual funds is that their betas are
relatively intertemporally more stationary than betas for individual stocks.4
Nevertheless, most studies in testing the TMCAPM used stock portfolios
rather than mutual funds partly because the time series data for stocks are
readily available.
The sample used in this study consisted of 43 randomly selected mutual
funds whose quarterly prices, cash dividends, and capital gains were reported
in Wiesenberger (1970-1986) from March 1970 to December 1986. The
sample data have been adjusted for stock dividends and stock splits so that
the adjusted data represent consistent schedules over the entire period. Rates
of return on each fund, Rit, for each quarter have been computed as
i=1,2 ,_.., 43, t=1,2 ,..., 67,
(4)
where Pi, is the net asset value of the ith fund at the end of the tth period,
Di, is the per-share dividend paid, and G,, is the capital gains distributed on
the ith fund during the tth period. The arithmetic mean return, &, for each
fund over the test period is then calculated.
The Standard and Poors 500 Composite Stock Index (S&L P 500) is used
There has been a great deal of literature concerning the stability of portfolio betas with
respect to the betas for individual stocks. For a recent review of this literature, see Alexander
and Chervany (1980). They showed that beta was more stable in more diversilied portfolios.
454 K.-J. Tan. Risk return and three-moment capital asset pricing model
Table 3
Market parameters based on Standard and Poors composite index.
Parameter 1970-1978 1979-1986 1970-1986
Quarterly market
return 0.01651 0.04377 0.02953
Variance of market
return 0.00929 0.00522 0.00753
Raw skewness of
market return - 0.00034 - 0.00003 - o.Oc@27
Relative skewness
of market return -0.37879 - 0.06343 -0.41570
Market risk premium 0.00187 0.01946 0.01027
Relative skewness of market return is determined by (M~/(s&.
as the market proxy. The market rates of return, RMlr for a given quarter c
have been obtained from the following formula:
Rhlr=C(P~t-Phltr-l))+DhltllP~,t-l), t=L2,...,67, (5)
where P,, is the level of the index at the end of tth period, and DMI is the
dividend paid during that period. The relevant market parameters for three
time periods 1970-1978, 1979-1986, and 1970-1986 are found in table 3. As
can be seen from table 3, the 1979-1986 subperiod has a higher quarterly
market mean return but a smaller variance and skewness of market returns
than the 1970-1978 subperiod. Furthermore, table 3 shows negative raw
skewness and relative skewness of market returns in all three test periods.
Using the quarterly values of Ri, and R,,, the values of the parameters for
each fund, PiM and giM, have been calculated using the following formulas:
PiM= ~ (Ra-Ri)(RMr-Rhl) ~ (R,,-R,)
i
(6)
t=1 I=1
and
giM=,zl (Ri,-Ri)(RMr-aM)
(7)
Summary statistics for betas and gammas are given in table 4. In the
1970-1978 sample, all beta and gamma values are positive. The mean beta
and gamma values are close to one. This result is consistent with the values
of beta and gamma of large portfolios. In this sample, mean beta and mean
Table 4
Mutual funds betas and gammas.
1970-1978
Beta Gamma
1979-1986 1970-1986
Beta Gamma Beta Gamma
Mean
Standard
deviation
Maximum
Minimum
Correlation
coeflicient
0.927 0.94 I 0.932 0.407 0.843 0.746
0.25 I 0.402 0.252 1.698 0.209 0.269
1.581 2.09 1 1.830 4.716 1.507 1.416
0.240 0.339 0.453 - 3.777 0.33 1 0.099
0.498 0.408 0.696
gamma are about the same. In the 1979-1986 sample, however, mean gamma
is significantly less then mean beta. This is partly because the second sample
contains no negative values for beta but has twenty negative values for
gamma. One important point emerges from table 4; it concerns the stability
of these two parameters. Table 4 clearly shows that the mean beta
maintained its value from one period to another, whereas the mean gamma
did not. This point has a major effect on the results we obtained later.
Another point in table 4 that should be mentioned here is that the mean
beta for the period 1970-1986 is far outside the range defined by the mean
betas of the subperiods 1970-1978 and 1979-1986. This situation can happen
if the constant term differs for the two periods although the betas are similar.
If this is the case, then a structural change has occurred in the market. This
may later on explain why the beta coefficients examined in the regression
analysis are found insignificant.
To isolate the effects of risk it is often useful to work in terms of risk
premium. As shown in eq. (l), the dependent variable is expressed in terms of
the expected risk premium for fund i. The average three-month market yield
on treasury bills is used as the proxy for the risk-free rate. Based on the
information on the risk-free rate, mean returns, and eqs. (6) and (7), the
quarterly cross-sectional regressions of the ith mutual funds expected risk
premium on its beta and gamma are run.
When both beta and gamma are used in the same equation, there may be
a high degree of correlation between them. It is shown in table 4 that
correlation coefficients between betas and gammas for the three time periods
are 0.498, 0.408, and 0.696, respectively. In order to eliminate gammas
relationship with beta, a two-stage modeling procedure used by Schweser
and Schneeweis (1980) is applied. These regressions are given as
and
gih4 = cO + cl 8iM (8)
K.-J. Tan. Risk return and three-moment capital asset pricing model
Table 5
Regression results of each of the 43 mutual funds. 197G1986.
Equations ( I), (2), or (3)
&RF=0.5760+0.7028/?,,-0.3307g,,, F= 1.528, RZ=0.071
(2.28)b (1.73) (- 1.05)
Equation (8)
gIM= -0.0061+0.8923&,, F= 38.449b, R* =0.484
(-0.05) (6.20)b
Equation (9)
Ri-~F=0.5780+0.4077~,,-0.33~6~i, F= 1.531, ~~=0.071
(2.29) (1.40) (- 1.05)
Theoretical values
a,=O, a,=l.O, a2=0.8
Equation (10)
R,-~~=0.5780+0.4077fi~~. F= 1.957, ~~=0.046
(2.28)b (1.40)
Theoretical values
d,=O, d,=l.O, d,=O
Coefficient units are quarterly data, percent per quarter.
%-statistics significant at the 57; level.
V-statistics significant at the 10% level.
Ri-RF=ao+a,fliM+a2ei, (9)
where e, in eq. (9) is the residual of eq. (8). Tests also are conducted on the
traditional CAPM presented as
(10)
The traditional CAPM predicts
do=O, d, >O, dz=O, and &-RF=dl
4. Empirical results
The results of these