BUFN 740: Capital Markets
Topic 4
Multifactor Models and Market Efficiency
(BKM 11, 12, 13)

BUFN 740: Capital Markets Topic 4

1

Multifactor Asset Pricing Models
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CAPM is a model that can be used to (1) explain why certain firms have certain returns; and (2) estimate expected return (discount rate). But it does not work.

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The empirical failure of CAPM leaves room for improvement

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Maybe we should not use the market portfolio return as the only systematic factor
– The market portfolio might not be representative

BUFN 740: Capital Markets Topic 4

2

Multifactor Asset Pricing Models (Cont.)
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Some potential choices
– Add a bunch of macro economic variables, e.g., change of industrial production, change in interest rates, as factors since they are by definition systematic risk that cannot be diversified away – Or just regard those pervasive “anomalies” as additional factors

BUFN 740: Capital Markets Topic 4

3

Fama and French (1993): Three Factor Model
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The factors in the Fama and French (1993, JFE) three-factor model: – MKT(t): The return on the market (value-weighted) in excess of the T-bill rate
– SMB(t) (Small minus Big): The return on small-cap stocks
(bottom 50%) minus the return on large-cap stocks (top 50%)
– HML(t) (High minus Low): The returns on high book-tomarket stocks (top 30%) minus those on low book-to-market stocks (bottom 30%) ri  rf  ai  bi  MKT  si  SMB  hi  HML  ei
E  ri   rf  ai  bi  E  MKT   si  E  SMB   hi  E  HML 
BUFN 740: Capital Markets Topic 4

4

The Value Premium
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Growth stock: High market value relative to accounting measures of value
– Growth: high stock price reflects capitalized growth opportunities Value stock: Low market value relative to accounting measures
– Value: physical assets-in-place can be acquired at low prices
Value stocks earn higher returns than growth stocks on average
(e.g., Fama and French 1992, 1993), the difference is called the value premium
The value premium reliable around the globe: Fama and French
(1998)

BUFN 740: Capital Markets Topic 4

5

Lakonishok, Shleifer, and Vishny (1994): Behavioral
Overreaction
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Fama and French (1992) believe that the value premium exists because value firms are more risky, probably reflecting distress risk Lakonishok, Shleifer, and Vishny (1994): Not a risk story, but due to behavioral overreaction
– Growth stocks are priced too high because they are glamorous – Value stocks are priced too low because they are out of favor
– Naive investors extrapolate past performance too far into the future – Value strategies bet against naive investors, outperform the market BUFN 740: Capital Markets Topic 4

6

Momentum: A Fourth Factor
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The original Fama-French model augmented with a momentum factor has become a common four-factor model used to evaluate abnormal performance of a stock portfolio.

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Momentum may be related to liquidity.

BUFN 740: Capital Markets Topic 4

7

Efficient Market Hypothesis (EMH)
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Do security prices reflect information ?
EMH and Competition
– Stock prices fully and accurately reflect publicly available information. – Once information becomes available, market participants analyze it.
– Competition assures prices reflect information.
Why look at market efficiency?
– Implications for business and corporate finance
– Implications for investment

BUFN 740: Capital Markets Topic 4

8

Figure 11.1 Cumulative Abnormal Returns Before Takeover
Attempts: Target Companies

BUFN 740: Capital Markets Topic 4

9

Figure 11.2 Stock Price Reaction to CNBC Reports

BUFN 740: Capital Markets Topic 4

10

Efficient Market Hypothesis
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Forms of the EMH
– Weak
– Semi-strong
– Strong
Types of stock analysis
– Technical Analysis - using prices and volume information to predict future prices.
» Weak form efficiency & technical analysis

– Fundamental Analysis - using economic and accounting information to predict stock prices.
» Semi strong form efficiency & fundamental