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Empirical tests of asset pricing models

Davies, Philip R

Abstract Details

2007, Doctor of Philosophy, Ohio State University, Business Administration.

The Capital Asset Pricing Model (CAPM) developed by Sharpe (1964)and Lintner (1965) is widely viewed as one of the most important contributions to our understanding of finance over the last 50 years. The CAPM predicts that non-diversifiable risk (beta) is the only risk that matters for the pricing of assets, and that an asset's expected return is a positive linear function of its non-diversifiable risk. However, the empirical performance of the CAPM has been poor. This poor performance may reflect theoretical failings. Alternatively, it may be due to difficulties in implementing valid tests of the model. This dissertation focuses on the second possibility.

In the first essay I develop a Bayesian approach to test the cross-sectional predictions of the CAPM at the firm level. Using a broad cross-section of NYSE, AMEX, and NASDAQ listed stocks over the period July 1927 - June 2005, I find evidence of a robust positive relation between beta and average returns. Fama and French (1993) propose two additional risk factors related to firm size and book-to-market equity. I find no evidence that these additional risk factors help to explain the cross-sectional variation in average returns. These results are consistent with the empirical predictions of the CAPM.

The use of portfolios as test assets in cross-sectional tests of asset pricing models is widespread, principally to help mitigate statistical problems. However, there is a considerable theoretical literature showing that the use of portfolios can make bad models look good, and good models look bad. In the second essay I investigate whether inferences from portfolio level studies can be generalized to the firm level. Using the Bayesian approach developed in the first essay, I find that inferences at the portfolio level are closely linked to the way in which portfolios are formed, rather than the underlying firm level associations. These results raise questions about what we can really learn from empirical asset pricing studies that use portfolios as test assets.

Rene Stulz (Advisor)
119 p.

Recommended Citations

Citations

  • Davies, P. R. (2007). Empirical tests of asset pricing models [Doctoral dissertation, Ohio State University]. OhioLINK Electronic Theses and Dissertations Center. http://rave.ohiolink.edu/etdc/view?acc_num=osu1184592627

    APA Style (7th edition)

  • Davies, Philip. Empirical tests of asset pricing models. 2007. Ohio State University, Doctoral dissertation. OhioLINK Electronic Theses and Dissertations Center, http://rave.ohiolink.edu/etdc/view?acc_num=osu1184592627.

    MLA Style (8th edition)

  • Davies, Philip. "Empirical tests of asset pricing models." Doctoral dissertation, Ohio State University, 2007. http://rave.ohiolink.edu/etdc/view?acc_num=osu1184592627

    Chicago Manual of Style (17th edition)