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Financial Modelling Notes

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74 views

Financial Modelling Notes

Uploaded by

Rafan Ahmed
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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 CAPM Anomalies

 The size effect


 The value effect
 The momentum effect
 APT
– Types of factors risk models:
 Single-index model
 Multi-index model
– APT and CAPM

The size effect


• Firms with a low market capitalisation (small caps) seem to earn positive abnormal
returns
• Size and beta are very strongly correlated
• Small firms typically have high betas
• Small caps generally outperform big caps of comparable beta
• Estimates for the abnormal return on small caps are around 2-4% p.a.
• Taking the expectations of both sides of the above equation will yield:

• E ( Ri ) −r=α i + [ E(R m)−r ] βi

• CAPM states: E(R i)−r=[ E( R m )−r ] βi

• Hence, we have αi = 0 under the CAPM assumptions


• But it was noticed that “small firms” often had positive “alpha” and large firms often
had negative alpha
• This was termed as the “small firm effect”

The value effect


• Stocks with a high market value relative to company fundamentals (earnings, dividend, book
value) are referred to as 'growth stocks'
• These have a (i) High price-to earnings ratio (P/E); (ii) Low dividend-to-price ratio (D/P); (iii)
Low book-to-market ratio (B/M)
• By contrast, ‘value stocks’ have a low market value relative to the company fundamentals
• These have a (i) Low price-to earnings ratio (P/E); (ii) High dividend-to-price ratio (D/P); (iii)
High book-to-market ratio (B/M)
• Value stocks seem to earn abnormal high average returns while growth stocks earn negative
abnormal returns
• The abnormal return on value stocks estimated at about 4–6% p.a.

The momentum effect


• In the short run i.e. for a period of up to a year, losers in the past continue to lose
while winners continue to gain
• It is stronger than the size and value effects → estimates range from about 4-6% p.a.
• However:
• Requires very high turnover: transactions costs and taxes are an issue
• Most of the return to the 'winner – loser' is due to the poor performance of the
loser: short positions are necessary
• It is stronger amongst small-cap stock: liquidity issues

Seminar
Regressing returns for Stock A against returns for the market portfolio yielded the following results:
Stock A’s alpha is 2%, Stock A’s beta is 2, and the standard deviation of Stock A’s returns is 40%. The
standard deviation of the market’s returns is 10%. A. Where does Stock A’s characteristic line
intercept the vertical axis? B. What is the slope of Stock A’s characteristic line? ANSWER: A. Alpha
is the intercept for the characteristic line (a = 0.02). B. Beta is the slope of the characteristic line (b =
2).
Despite the fact that the CAPM has unrealistic assumptions and that it is difficult to test empirically,
the CAPM is widely applied in practice. Discuss for which purposes the CAPM is applied.
ANSWER: CAPM is used for: Portfolio selection: the beta is a popular measure of market timing.
Performance evaluation: the alpha and beta allow an investor to assess whether or not a fund manager
is earning his or her pay. Risk management: beta measures the dependency of an asset on the other
available assets by a single number. It can be used in the Value-at-Risk framework. Capital budgeting:
financial managers can calculate the cost of equity using CAPM.
QUESTION 3 Discuss the three most documented inconsistencies with the CAPM, also known as
stock market anomalies, observed in capital markets. ANSWER: The following well-documented
stock market anomalies exist: The size effect: firms with a low market capitalisation seem to earn
positive abnormal average returns; while firms with high market capitalisation earn negative abnormal
returns. The value effect: stocks with a low market value relative to firm fundamentals (low priceto-
earnings ratio, and high dividend-to-price ratio, as well as a high book-to-market ratio) seem to earn
positive abnormal average returns; while growth stocks (high price-to earnings ratio, and low
dividend-to-price ratio, as well as a low book-to-market ratio) earn negative abnormal average returns.
The momentum effect: in the short run (periods up to a year) one seems to be able to predict abnormal
returns based on abnormal returns from the past. That is, the losers from the past continue to lose
while the winners continue to win.

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