15.

433 INVESTMENTS
Classes 8 & 9: The Equity Market
Cross Sectional Variation in Stock Returns

Spring 2003
 Introduction

Equities are common stocks, representing ownership shares of a corporation. Two

important characteristics:

• limited liability: non-negative stock prices,

• residual claim: equities are inherently more risky than fixed income securities.

In most countries, the equity market is perhaps the most popular venue of investments
for individual investors. It also remains to be an important component of institutional
investments. We will examine the equity market from two perspectives:

• cross-sectional (Classes 8 & 9 ), and

• time-series (Class 10).

 ”Cross-Section” vs. ”Time-Series”

These two concepts are empirically motivated. For a publicly traded firm i, the follow­
ing information can be readily obtained.

• The stock price Pi,t at any time t.

• The cash dividend Di,t−1 paid between t-1 and t.

At any time t, we can calculate the realized stock return for ri,t for firm i:
Pi,t +Di,t −Pi,t−1
• percentage returns: ri,t = Pi,t−1

• log-returns: ri,t = ln (Pi,t + Di,t − ln (Pi,t−1 ))

• cross-section of stock returns: ri,t ; i = 1, 2, . . . , N

• time series of stock returns: ri,t ; i = 1, 2, . . . , T

 The Cross-Sectional Distribution of
Returns
0.080

0.070

0.060

0.050

0.040

0.030

0.020

0.010

-
-0.150 -0.100 -0.050 - 0.050 0.100 0.150
-0.010

Normal-Distribution Current Distribution

Figure 1: Distribution of the Nasdaq-index returns for the year 2000, source: Bloomberg Professional

0.100

0.090

0.080

0.070

0.060

0.050

0.040

0.030

0.020

0.010

-
-0.080 -0.060 -0.040 -0.020 - 0.020 0.040 0.060
-0.010

Normal-Distribution Current Distribution

Figure 2: Distribution of the Nasdaq-index returns for the year 1999, source: Bloomberg Professional

0.140

0.120

0.100

0.080

0.060

0.040

0.020

-0.020
-0.100 -0.050 - 0.050 0.100

Normal-Distribution Current Distribution

Figure 3: Distribution of the Nasdaq-index returns for the year 1998 (from left to right), source:
Bloomberg Professional

What has changed, what has influenced the market?

 Multi-Factor Regressions

For each asset i, we use a multi-factor time-series regression to quantify the asset’s
tendency to move with multiple risk factors:

ri,t−1 − rf,t = αi + βi (rM,t − rf,t ) + fi Ft + εi,t

• 1. Systematic Factors:
rM,t : risk premium λM = E (rM,t − rf )
Ft : risk premium λF = E (Ft )

• 2. Idiosyncratic Factors:
εi,t : no risk premium E (εi,t )

• 3. Factor Loadings:
βi,t : firm’s sensitivity to the market risk
fi,t : firm’s sensitivity to the factor risk
See BKM
p. 559 - 572
and article
from Fama
(1992)
 The Pricing Relation

Using the intuition of the CAPM, the reward for asset i should be related to its expo-
sure to the market risk, as well as its exposure to the systematic risks.

Given the risk premia of the systematic factors, e.g., λm and λF , the determinants of
expected returns:

E (ri,t−1 − rf,t ) = βi · λM + fi · λF (1)

Without the systematic factors F, we are back to the CAPM.

What are the additional systematic factors?

The intuition of the CAPM: these factors should be proxies for the real, macroeco­
nomic, aggregate, non-diversifiable risk.
 Size: Small or Big

We can sort the cross-section of stocks by their Market Capitalizations:

”Share Price x Number of Shares Outstanding”

Cap Market NYSE NYSE AMEX NASDAQ Total

Decile Cap(m$) Ticker Stocks Stocks Stocks
10 511,391 GE 172 5 80 257
9 10,486 NSM 172 3 81 256
8 4,428 GLM 172 5 136 313
7 2,237 BLC 172 5 166 343
6 1,387 GES 172 5 217 394
5 889 SFG 172 11 254 437
4 534 PNK 172 15 251 438
3 353 FFD 172 32 400 604
2 198 SXI 172 73 551 796
1 95 AVS 172 412 1,399 1,983

Size Range as of December 31, 2000. Source: www.dfafunds.com.

 Value or Growth

We can also sort the cross-section of stocks by their Book-to-Market (BtM) ratios:
• Growth Stocks: Firms with low BtM ratios
• Value Stocks: Firms with high BtM ratios.

Decile BtM NYSE NYSE AMEXS NASDAQ Total

Ticker Stocks Stocks Stocks
1 0.01 IN 155 71 824 1,050
2 0.14 SYY 155 31 362 548
3 0.25 TDX 155 36 223 414
4 0.36 STJ 155 24 177 356
5 0.45 FLO 155 37 229 421
6 0.58 DOL 155 43 248 446
7 0.72 HCC 155 56 274 485
8 0.92 TWR 155 51 251 457
9 1.19 MTN 155 71 279 505
10 1.81 ZAP 155 58 195 408

Value and Growth Definitions as of December 31, 2000. Source: www.dfafunds.com

 Portfolios Formed on Size and BtM

Sort the stocks traded on the NYSE, NASDAQ, and AMEX by their size and BtM.

Size labels: A (small), B, C, D, and E (big).

BtM labels: 1 (low), 2, 3, 4, and 5 (high).

• low BtM growth stocks

• high BtM value stocks

The 25 Fama-French Portfolios:

A B C D E
(s) (b)
1 (l)
2
3
4
5 (h)
 Explain the Fama-French Portfolios

Start with the one-factor empirical model:

ri,t − rf,t = αi + βi (rM,t − rf,t ) + fi Ft + εi,t (2)

For each portfolio i, we perform the above regression and obtain an estimate βˆi of
the factor loading βi . This regression procedure is equivalent to constructing sample
estimates for βi , why?

Estimate the market risk premium:

1�
T
λ̂M = (rM,t − rf,t ) (3)
T i=1

The mean excess return: E (ri,t − rf,t )

• The model predicted: βˆi · λ̂M

1
�T
• Measured from the data: T i=1 (ri,t − rf,t )
 A One-Factor Model (CAPM)

Figure 4: One-factor model, Source: Jun Pan, Investments 15.433 Spring 2001.
 A Three-Factor Model

The Fama and French empirical Factors:

• SMB rsmb : small minus big - return on the small portfolio minus that on the big
portfolio;
• HML rhml : high minus low - return on the high BtM portfolio (value) minus that
on the low BtM portfolio (growth).

A three-factor regression model:

ri,t − rf,t = αi + βi (rM,t − rf,t ) + si · rsmb,t + hi · rhml,t + εi , t (4)

Pricing Relation:

E (ri,t ) − rf,t = βi · λM + si · λsmb,t + hi · λhml,t (5)

where λsmb and λhml are the risk premiums of the Fama-French factors.
 The Fama-French Three-Factor Model

Figure 5: Fama-French three factor model, Source: Jun Pan, Investments 15.433 Spring 2001.
 The Factor Premia

Using monthly returns from 1963 to 2000, the (annualized) premia for the three factors
are:

Factor Estimate S.E. t-stat

Market 6% 2.5% 2.5%
SMB 1.9% 1.9% 1%
HML 5% 2% 2.6%

The Market Risk Premium

The market risk premium has its foundation in the CAPM.

Investors are risk averse. They are worried about holding stocks that do badly at the
times when the market does badly.

The market risk premium is a reward for holding the market risk.
 What are the Size and Value Factors?

Unlike the market portfolio, the Size and Value portfolios are empirically motivated.
Where do the size and value premia come from?

If we think of them as risk premia, then we need to understand the real, macroeco­
nomic, aggregate, non-diversifiable risk that is proxied by the SMB and HML portfolios.

In particular, why are investors so concerned about holding stocks that do badly at
the times that the hml and smb portfolios do badly, even though the market does not
fall?

Some Explanations

Value: proxies for the ”distress risk”.

Size: proxies for the illiquidity of the stock.

HML and SMB contain information above and beyond that in the market return for
forecasting GDP growth.

Proxies for variables that forecast time-varying investment opportunities or time-varying

risk aversion.

Over-reaction: earnings announcements.

Seasonal: the January effect.

Survival bias.

Data snooping
 Other Factors

Empirical Factors: price-to-earning ratios, strategies based on five-year sales growth,

etc.

Macroeconomic Factors: labor income, industrial production, inflation, investment

growth, consumption wealth ratio, etc.

The Market Skewness Factor:

• If asset returns have systematic skewness, expected returns should include rewards
for accepting this risk.
• Co-Skewness: the level of exposure to the systematic skewness.
• Harvey and Siddique (Journal of Finance 2000) report that systematic skewness
is economically important and commands an average risk premium of 3.60 per
year.

Long-Term Reversals
Firms whose three- and five-year returns are high (low) tend to have low (high) returns
in subsequent years.

Firms with low (high) BE/ME, E/P, CF/P, D/P, and prior sales growth tend to have
low (high) returns in subsequent years.

All these patterns seem to be manifestations of the same value vs. growth phenomenon.

This ”reversal” effect makes sense given return predictability and mean-reversion, and
is explained by the Fama-French three factor model.

Short-Term Momentum
Firms with high returns in the prior year tend to have high returns in the next few
months.

Firms with low short-term returns tend to have low returns in subsequent months.
At the moment, the momentum effect is the most-studied anomaly in Finance. It
cannot be explained by the Fama-French three factor model.

Risk-based stories: Proxy for systematic skewness: the low expected return momentum
portfolios (losers) have higher skewness than high expected return portfolios (winners).

Behavioral (non-risk- based) stories:

• 1. underreaction: bad news travels slowly;
• 2. overreaction: positive feedback;
• 3. overconfidence.
 Beta Hedging
Recall that:

E (ri ) = rf + βi (E (rM ) − rf ) (6)

where

cov (rM , ri )
βi = (7)
var (rM )

Let’s assume we are long-beta, e.g. β = 1.3, and we are not optimistic about the
short-term outlook of the market. We anticipate some bade earnings numbers, which
will send the market down . . . and our portfolio even faster. Let’s hedge our Beta-
Exposure!

ΔP ΔM
≈β (8)
P M

A stock index futures contract worth:

ΔP ΔM
≈β (9)
P M

The generated change in portfolio value ΔV due to an adverse change in the market
ΔM is:

ΔV = ΔP + N ΔF (10)
ΔM ΔM
= β·P +N ·F (11)
M M

The optimal N∗ isN ∗ = − β·P

F
(12)The optimal hedge with a stock index futures is given
by beta of the portfolio times its value divided by the notional of the futures contract.

Example: A portfolio manager holds a stock portfolio worth $10 mio., with a beta
of 1.5 relative to S&P 500. The current S&P 500 index futures price is 1400, with a
multiplier of $250.

Compute:
 1. The notional of the futures contract
2. the optimal number of contracts to hedge the beta-exposure against adverse mar­
ket movements.
Solution:
1. The notional of the futures contract is:

$250 · 1� 400 = $350� 000 (13)

2. the optimal number of contracts to hedge the beta-exposure against adverse mar­
ket movements is:
β·P 1.5 · $10� 000� 000
N∗ = − =− = −42.9 (14)
F 1 · $350� 000
However:

A typical US stock has a correlation of 50% with the S&P 500-index. Using the
regression effectiveness we find that the volatility of the hedged portfolio is still about
(1 − 0.52 = 87%) of the unhedged volatility for a typical stock.
If we wish to hedge an industry index with S&P futures, the correlation is about 75%
and the unhedged volatility is 66% of its original level.
The lower number shows that stock market hedging is more effective for diversified
portfolios.
 Summary
The cross-sectional variation in stock returns cannot be fully explained by beta. Adding
additional factors (size and value) helps.

While the risk premium associated with the beta risk has its theoretical foundation in
the CAPM, the premia associated with the size and value factors do not.

There are many other puzzling patterns in stock returns, some of which are hard
to reconcile with market efficiency.

Focus: Patterns in the Cross-Section of Stock Returns

• Reader: Fama and French (1992)
type of potential questions: how is value / growth style etc. defined? What was the
general setup of the style analysis?

Focus: More Patterns in the Cross-Section of Stock Returns

• Cochrane (1999),
• Kritzman (1991a), and
• Kritzman (1991b)
type of potential questions: Cochrane: p. 39 to 43, 50 to 51, Kritzman: historical vs.
implied volatility, normal assumption of volatility vs. nonlinearity
 Questions for Next Class
Please Plase read for class 9:
• BKM 13.4 and 13.5
• Cochrane (1999), Kritzman (1991a) and Kritzman (1991b)

In the next class, we will examine stock returns from a time-series perspective.

Our focus is on dynamic models that allow for:

• 1. time varying expected return µt

• 2. and time-varying volatility σt

Why are these issues important?

Please read for class 10: BKM Chapters 20.