Assignment Asset Pricing

Erik Kole

Deadline: Tuesday, October 7, 2014, 23h59

Introduction
In this assignment you will test several asset pricing models on various portfolios. As
we have discussed in the lectures, we prefer portfolios of stocks to single stocks for at
least two reasons when testing asset pricing models. First, while the characteristics of
individual companies may change because of their phase in the company life cycle, we
expect the characteristics of portfolios to stay constant when we periodically rebalance
them. Second, companies entering or leaving the set of observations, because of IPOs,
mergers, acquisitions or bankruptcies do not cause problems when we have portfolios.
The most straightforward way of forming portfolios is based on industry classications.
The US Census Bureau attributes a Standard Industry Classication (SIC) to each rm
in the form of a 4-digit number. Based on these numbers, industries can be dened. One
of those industries is Telecom. All rms with SIC codes between 4800 and 4899 belong to
this industry. We can also base portfolios on other company characteristics such as size or
book-to-market ratios, or trading strategies such as momentum.
In this assignment we consider the cross section of returns on size, value, momentum and
industry portfolios. I have selected 20 portfolios, 5 based on size quintiles (S1 to S5; ordered
from small to big), 5 based on value quintiles (V1 to V5; ordered from low to high book-to-

For questions, please send an e-mail to kole@ese.eur.nl.

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market ratio), 5 based on momentum quintiles (M1 to M5; ordered from losers to winners)
and 5 based on industries. The 5 industries are Consumer Goods (Cnsmr), Manufacturing
(Manuf), High Tech (HiTec), Health Care (Hlth) and Other (Other) containing all still
unclassied rms. A time series of returns of the dierent portfolios can be found in the
Excel le data14.xls, also available on Blackboard.
General instructions
1. You are allowed to work in groups of two.
2. The assignment is unique for each group of students, as the start and end date of
the data set to use is indicated in a separate Excel le (start end.xls). This tells
you what you should take as start date and end date of your sample. If you decide
to work together, you should take the start date and end date for the student with
the lowest student number.
3. Students in FEM11008 should make parts one, two and three, and can skip part
four. Students in FEM21003 should make all parts. Students in FEM11008 can try
to make part four and obtain a bonus based on their results.
4. Parts 1 to 3 of the assignment can be done in Excel and/or Matlab. Part 4 cannot
be done in Excel, but Matlab (or another programming language like Ox or R) works
ne. You are free to use any program you prefer (e.g. Matlab). Always discuss in
the report which steps you take. Please add any program code as an appendix to the
report.
5. Indicate which numbers are what in your calculations (you can use the same style as
I did in the examples), and put comments in your programming code.
6. To allow ecient grading, you should hand in part of your answers in a specially
designed Excel le. A discussion of your analysis and results should be made in a
report (Word or PDF le).
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A basic answer-sheet in Excel is included in the data le.
The answer sheet should contain the answers in column C. After each question I
will indicate where to put it. The top cells (C1-C2) should contain your student
number(s).
The cells on the answer sheet can simply contain numbers.
If you make the assignment in Excel, you will probably use multiple worksheets.
You can include them in the Excel le you hand in. Label them with the FIRST
question for which I can nd calculations (Q1 for the rst question, if the next
sheet is labeled Q4, I assume that the calculations for question 2 and 3 are on
sheet Q1 as well.) Your answers on the answer sheet do not have to contain
references to the other sheets. (You can paste the answer there by choosing
Paste Special > Values in the Paste menu. Also note the option Transpose in
this menu.)
7. The Excel le should have your student number as its name (with extension .xlsx, e.g.,
345678ab.xlsx). If you work together with a fellow student, the le name should con-
tain the two student numbers separated by an underscore (e.g., 345678ab 356789cd.xlsx).
The same applies to the Word or pdf-le, so students numbers separated by an un-
derscore with extension docx or pdf.
You should hand in the assignment before October 7, 2014, 23h59 via the Assignment
part on Blackboard. Be sure to press the submit button. Pressing save as
draft enables you to continue working and does NOT make the le available
to me. Your grade for the assignment is your number of points divided by the total
number of points, multiplied by 10. You will receive a message via SIN-online messaging
informing you of the grade you have obtained.
This Excel setup enables me to check quickly which answers are correct. Of course,
if the answer to, say, question 3 is wrong, this may inuence your answer to the next
question. I will take that into account, so you can still get the full set of points for the
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following questions.
Notes on Excel and Matlab
The Excel functions STDEV and VAR return unbiased estimates of the standard devia-
tion and variance, i.e. they calculate

Var[X] =
1
T1

T
t=1
(x
t

E[x
t
])
2
. The functions
STDEVP and VARP divide by T instead of T 1. These are the ones you need! For
Matlab, the same applies to the function Var. Here you can use Var(x,1).
The Excel functions CHIDIST and FDIST and TDIST return one-sided p-values, i.e.
Pr[Z z].
You should use the closed-form solution for the estimates discussed in class (Lecture
8). Links on Blackboard help you using the array functions MMULT and MINVERSE
for matrix multiplication and matrix inverse. While you can use Excels solver to
perform minimizations, (Data > Solver; if you do not see that in the menu Data, go
to Excel Options > Add-Ins, click Go and check the Solver Add-in), the answers are
sometimes unreliable.
Notes on the data
The column Rf contains the risk-free rate in % per month.
The columns Rm-Rf, SMB, HML, MOM contain the excess return on the market, the
return on the size portfolio and the value portfolio as constructed by Fama and
French (1993), and the momentum portfolio. This last portfolio is constructed from
six value-weighted portfolios formed using independent sorts on size and prior return
of NYSE, AMEX, and NASDAQ stocks (measured from month -12 to - 2). All values
are excess returns in %.
The returns on the test assets are raw returns in %, so R
i,t
= p
i,t
/p
i,t1
1. You
have to transform them to excess returns.
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For estimation and testing, the scale of the returns does not matter, so you can work
with returns as a rate (e.g. 1.05) or as a (e.g., 5%). For other calculations (e.g. the
ecient portfolio), you should use rates.
Questions (60 points)
Part 1: The Carhart Model and GRS (14 points)
In this rst part, you conduct a GRS-test of the four factor model of Carhart (1997) on
the 20 test assets, similar to our testing of the CAPM in Lecture 2. The Carhart model
contains four factors. i.e., the excess return on the market, and the returns on the size,
value and momentum portfolios. The general form of the model for assets i = 1, 2, . . . n is
given by
R
i,t
R
f
t
=
i
+

i
f
t
+
i,t
, E[
i,t
] = 0, E[
2
i,t
] =
2
i,t
, (1)
where R
i,t
is the return on asset i at time t, R
f
t
is the risk-free rate, and f
t
is a k-vector
with factor realizations.
i
contains the pricing error for asset i, is a k-vector of factor
sensitivities, and
i,t
contains the error term. All error terms have expectation zero and
asset-specic variance
2
i
. They may be correlated across assets, E[
i,t

j,t
] =
ij
for i = j,
but are independent over time, E[
i,t

j,t+s
] = 0, i, j, s = 0.
Conduct the GRS-test with the following steps and intermediate results.
1. (2 points) Estimate the parameters of the model in eq. (1). Report your estimates for
the market- in cells C4:C23, for the size- in C25:C44, for the value- in C46:C65,
for the momentum- in C67:C86, and your estimates for in cells C88:C107.
2. (4 points) Test whether each
i
is signicant. Report the standard error for each

i
(C109:C128), and the p-values in C130:C149. Explain how you calculated the p-
values (be explicit on the degrees of freedom), and discuss your results in the report.
In this discussion, pay attention to potential patterns in the mispricing, size of the
pricing errors, and the number of signicant estimates for .
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3. (4 points) Conduct a (nite sample) GRS test. Report the value for

1
in C151.
Report the GRS-statistic in C153. Report the two degrees of freedom parameters in
C155:C156 and the p-value of the test in C158. Explain how you calculated the p-
values (be explicit on the degrees of freedom), and discuss your results and conclusion
in the report.
4. (4 points) Calculate the Sharpe ratio of the ecient portfolio formed by the model
assets (the market, size, value and momentum portfolios), and the Sharpe ratio of
the ecient portfolio constructed from the combination of model and test assets
(C160:C161). Explain your steps in the report, and discuss the result. Is the dier-
ence between Sharpe ratios signicant?
Part 2: The Fama-French Model and GMM (28 points)
Next, we conduct tests for the Carhart model in a GMM-setting. The pricing kernel is
given by
m
t
= a +b

f
t
, (2)
with f
t
as dened in the previous part. a is a scalar and b is a k-vector of coecients. As we
work again on excess returns, the mean of the pricing kernel cannot be identied from the
test assets. We use the relation E[m
t
] = a+b

E[f
t
] = 1/R
f
to determine a = 1/R
f
b

E[f
t
]
for a user-specied value for R
f
. For the moment, you can put R
f
equal to the average
value of the risk-free rate for your sample.
Test the Carhart model with the TJ-test with the following steps and intermediate
results.
5. (2 points) Estimate the bs in a GMM framework in such a way that the sum of
quadratic average pricing errors is minimized (so with W = I). Report the b esti-
mates (C163:C166) and the average pricing errors (C168:C187).
6. (4 points) Compute the variance matrix S of the pricing errors. Conduct the second
step of GMM estimation: estimate the bs again (C189:C192), now using the inverse
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of the variance matrix as a weighing matrix (so use W = S
1
as objective). Report
the average pricing errors in cells C194:C213. Compare both sets of average pricing
errors and discuss your ndings in the report. For which portfolios did they increase
in absolute value. Explain why these changes happen.
7. (4 points) Test for each portfolio whether its average pricing error is signicant.
Report the p-values in cells C215:C234. Compute the TJ-statistic (C236), and calcu-
late its p-value (C238). Explain how you calculated the p-values (be explicit on the
degrees of freedom), and discuss your results and conclusion in the report.
8. (3 points) Compute the risk premia for the four factors implied by the value of b
(C240:C243). Compare them to the average returns on the factors, and discuss your
ndings in the report. Explain why we observe dierences.
9. (6 points) A way to include the relation between the calculated risk premium and
the observed returns on the risk factors is by including the risk factors as test assets.
So besides the 20 portfolios we also include the market, size and value portfolios as
test assets (and we have in total 24 portfolios). Create a new GMM framework that
includes the risk factors as a test asset. Conduct the rst estimation step of GMM.
Report the estimates for the bs in cell C245:C248. Report the average pricing errors in
cells C250:C273. Calculate the variance matrix S of the pricing errors. Conduct the
second step of GMM estimation. Report the b estimates in cell C275:C278. Report
the average pricing errors in cells C280:C303. Compare these pricing errors to those
from Question 6, and the deviations on the risk premia in Question 8. Discuss and
explain your ndings in the report.
10. (4 points) Test for each portfolio whether its average pricing error is signicant.
Report the p-values in cells C305:C328. Calculate the TJ-statistic (C330) and its p-
value (C332). Discuss your results for this question, and compare them to the results
from Question 7. Explain which test outcome is more reliable.
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11. (5 points) Make a graph of the ecient frontier that corresponds with the four factors.
This ecient frontier corresponds with the pricing kernel. Include in the same graph
the ecient frontier that corresponds with combinations of the test assets and the four
factors. In both cases you can use the approach of Lecture 6, by using dierent values
for the (implicit) risk-free rate. Argue whether the two frontiers are signicantly
dierent.
Part 3: Carhart model with the squared market return (18 points)
It is a well-known fact that the volatility of nancial markets varies over time. The pricing
kernel may reect this characteristic. Therefore, we introduce the square of the excess
market return as an additional factor in the model of eq. (2). The vector f
t
now has size
5. As test assets we consider the 20 portfolios and the four portfolios from the Carhart
model.
Test this asset pricing model and compare it with the Carhart model with the following
steps and intermediate results.
12. (3 points) Explain in your report what sign you expect for the coecient on the
squared market return. Why cant we include it as a test asset?
13. (3 points) Conduct the rst step in GMM estimation. Report the estimates for b in
cells C334:C338. Construct the variance matrix of the pricing errors. Conduct the
second step GMM estimation. Report the estimates for b in cells C340:C344. Report
the average pricing errors (C346:C369).
14. (4 points) Test for each portfolio whether its average pricing error is signicant.
Report the p-values in cells C371:C394. Calculate the TJ-statistic (C396) and its
p-value (C398). Discuss your results for this question, and compare them to the
results from Question 10. Pay attention to the size of the pricing errors and their
signicance.
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15. (4 points) Test whether the pricing errors are signicantly dierent when you impose
the restriction that the b-coecient for the squared market return is zero. Report
the restricted TJ statistic in cell C400 and the dierence with the unrestricted TJ
statistic in cell C402, and the p-value in cell C404. Explain what steps you have taken
for the calculations and interpret the result. Is the squared market return a valuable
addition?
16. (4 points) We have considered four groups of test assets: size, value, momentum
and industry portfolios. Test whether the pricing errors are jointly signicant for
each of these four groups. Report the statistics in C406:C409 and their p-values in
C411:C414. Explain your approach in the report and discuss the outcomes. Are
there some groups of portfolios for which mispricing is more pronounced?
Part 4: Testing with HJ-weights (15 points)
The results of the previous part may rather reect changes in the spectral density matrix
S than an improvement in the model for the pricing kernel. All results so far are derived
using the optimal weighing matrix S
1
. We can remedy this by selecting a xed weighing
matrix, for example the Hansen-Jagannathan matrix E[rr

]
1
, which is the inverse of the
second moment matrix of excess returns on the 24 test assets.
Redo the analysis of parts 2 and 3 with the Hansen-Jagannathan weighing matrix with
the following steps and intermediate results.
17. (5 points) Estimate the parameters for the Carhart model of part 2. Report the b-
estimates in C416:C419, the average pricing errors in C421:C444, and their p-values in
C446:C469. Calculate the TJ-statistic (C471) and its p-value in C473. The variance
matrix of the pricing errors is not invertible, so you need to use a generalized inverse.
Discuss your results in the report and compare them to the results of Question 10.
18. (5 points) Estimate the parameters for the Carhart model extended with the squared
market return of part 3. Report the b-estimates in C475:C479, the average pricing
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errors in C481:C504, and their p-values in C506:C529. Calculate the TJ-statistic
(C531) and its p-value in C533. Discuss your results in the report and compare them
to the results of Question 14.
19. (5 points) Test whether the pricing errors are signicantly dierent when you impose
the restriction that the b-coecient for the squared market return is zero. Report
the restricted TJ statistic in cell C535 and the dierence with the unrestricted TJ
statistic in cell C537, and the p-value in cell C539. Explain what steps you have taken
for the calculations and interpret the result. Is the squared market return a valuable
addition? Discuss the dierence with the outcome in Question 15.
References
Carhart, M. M. (1997). On persistence in mutual fund performance. Journal of Finance, 52(1):57
82.
Fama, E. F. and French, K. R. (1993). Common risk factors in the returns on stocks and bonds.
Journal of Financial Economics, 33(1):356.
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