Investment Analysis and Portfolio Management Case2B
Case 2B: The Small/Large Anomaly Maastricht University
School of Business and Economics Maastricht, 15 September 2009
Maastricht University
School of Business and Economics Maastricht, 15 September 2009
Table of Content Introduction 3 Summary Statistics 4 Spread Portfolio 5 Evaluate the CAPM 6 Conclusion 7 References 8
Introduction
The Capital Asset Pricing Model (CAPM) is an equilibrium model that underlies all modern financial theory. It predicts the required rate of return of a security based on its risk, as measured by beta, and makes use of various simplifying assumptions. Hence, equilibrium condition would evolve with all investors choose to hold the same portfolio for risky assets, the “market” portfolio. However, following Fama and French’s study in 1992, numerous studies have suggested that beta is not sufficient in accounting for risk and recommend the inclusion of other variables. Most notably, Fama and French (1996) noted that stocks of smaller firms and stocks of firms with a higher book-to-market ratio have had higher stock returns than predicted by single factor models, and thus proposed a three-factor model that adds on firm size and book-to-market ratio to the market index.
In this paper, we will focus on the small-large anomaly, and examine empirically if it still exists in today’s market. We use the Russell 1000, Russell 2000 and Russell 3000 to represent the large cap, small cap and general market respectively. Firstly, we will present the summary statistics of the 3 return series over the last 15 years. Next, we will build and analyze a spread portfolio over the same period, and discuss the effectiveness of such a strategy. Finally, this paper will test the CAPM and its accuracy in the pricing of both small and large styles, and the spread.
Summary Statistics
This section will shortly introduce the different indexes used for our analysis, elaborate on the outcomes of the statistical
School of Business and Economics Maastricht, 15 September 2009
Maastricht University
School of Business and Economics Maastricht, 15 September 2009
Table of Content Introduction 3 Summary Statistics 4 Spread Portfolio 5 Evaluate the CAPM 6 Conclusion 7 References 8
Introduction
The Capital Asset Pricing Model (CAPM) is an equilibrium model that underlies all modern financial theory. It predicts the required rate of return of a security based on its risk, as measured by beta, and makes use of various simplifying assumptions. Hence, equilibrium condition would evolve with all investors choose to hold the same portfolio for risky assets, the “market” portfolio. However, following Fama and French’s study in 1992, numerous studies have suggested that beta is not sufficient in accounting for risk and recommend the inclusion of other variables. Most notably, Fama and French (1996) noted that stocks of smaller firms and stocks of firms with a higher book-to-market ratio have had higher stock returns than predicted by single factor models, and thus proposed a three-factor model that adds on firm size and book-to-market ratio to the market index.
In this paper, we will focus on the small-large anomaly, and examine empirically if it still exists in today’s market. We use the Russell 1000, Russell 2000 and Russell 3000 to represent the large cap, small cap and general market respectively. Firstly, we will present the summary statistics of the 3 return series over the last 15 years. Next, we will build and analyze a spread portfolio over the same period, and discuss the effectiveness of such a strategy. Finally, this paper will test the CAPM and its accuracy in the pricing of both small and large styles, and the spread.
Summary Statistics
This section will shortly introduce the different indexes used for our analysis, elaborate on the outcomes of the statistical
References: